What exactly do the banks look for when processing your loan application? In this two part feature, Rolf Schaefer of Metropole Finance walks you through the 4 C’s that the banks use to assess finance applications and explain how you can get them to approve your loan every time.
In Part two of Rolf’s article we look at the next three C’s of finance – Collateral, Capacity and Capital – and explain why structuring your loan in the right way is so critical.
The second “C” of credit is collateral; what you are offering the lender as security over your loan. For investors or home buyers, this would be some type of property.
Lenders favour certain properties over others when it comes to assessing a loan application. Is the collateral you are offering them a 15 square metre bedsitter or is it a four bedroom mansion in a blue chip suburb?
Something like student accommodation or a small one bed apartment is not considered preferred security by the banks, meaning you might be limited in regard to the loan you can get, if they will even give you one at all.
They may only be willing to look at a maximum Loan to Value Ratio (LVR) of 65 to 70%, the loan could come with a higher interest rate, the loan term could be reduced from 30 to 20 years and it is unlikely you would be offered an interest only product.
So it is critical, as an investor, to really be aware of this particular assessment criterion when considering the type of property you are planning on adding to your portfolio.
Another factor is location. A property in a blue chip suburb in one of our metropolitan cities is far more attractive to lenders than real estate in regional or rural Australia.
Essentially, the banks are so stringent with their assessment of the size, type and location of the property you intend to use as collateral because for them it comes down to the question of how much they can get if everything goes pear shaped and they are forced to sell the asset.
This situation is known as a fire sale. When you can no longer make your repayments, the bank must put your property on the market to recoup their funds, which they aim to do within 30 days. Hence, they assess your collateral’s potential risk on that basis, meaning if they think the property will be difficult to sell or will only fetch a very low price they will not want to give you a loan on that property.
This means that for investors with limited funds, you would be better off purchasing a smaller one bedroom apartment in a prime inner city location, as opposed to a one bedroom apartment in a country town, because nine times out of ten the lender would assess the first example much more favourably than the latter. To them, this represents more attractive collateral.
Your capacity to repay the loan is the third “C” and is commonly referred to as serviceability; where the bank looks at your employment income, either PAYG or self-employed, any rental income and all of your assets and liabilities.
The way banks assess your employment income is pretty self explanatory. They simply look at how much you have coming in each month and deduct from that how much you have going out for things like general living expenses (groceries, rent or mortgage, utilities, etc), personal loans and credit card debts.
One important aspect to note with regard to credit and store cards is that the higher your credit limits, the less capacity you have to meet your loan commitments in the eyes of the banks.
I always suggest that clients reduce their credit card limit wherever possible. We often see clients with up to $50,000 or even $70,000 credit card limits, but this can work against them because when it comes to the way the banks asses your serviceability and how much they will lend you, your existing credit limits makes a big difference. For instance, a $20,000 or $25,000 credit card limit may reduce the amount you can borrow by as much as $70,000 or $80,000.
When it comes to assessing rental income from an investment portfolio, lenders’ policies can vary significantly. A handful of lenders might be willing to take into account 100% of your rental income when considering your level of serviceability.
On the other hand, many of the big banks will limit the amount of rental income that goes toward their assessment of your ability to service the loan to as little as 75% or even 65%.
The reason some lenders look less favourably on rental income is that it’s not seen as stable earnings. They will factor in variables that can cause rental income to go up or down, such as vacancy periods, property management and insurance costs and things like maintenance and repairs.
Although this may not seem like a significant issue, think about it this way; if you have a property portfolio generating a rental income of $100,000 per annum and one bank uses that entire $100,000 to asses your ability to service your loans, whereas another bank uses only $75,000, that means you have a gap in your borrowing capacity of nearly $350,000 at current interest rates.
Essentially, this difference could mean that by borrowing from the bank who allows a more generous assessment of your rental income (at 100%), you are able to buy one extra property to add to your investment portfolio.
The fourth and final “C” is Capital; your deposit. This is also often referred to as the Loan to Value Ratio (LVR). If you are seeking an 80% LVR or lower (meaning you have a 20% plus deposit), then credit is relatively easy to come by. However if the LVR exceeds 80%, then the application has to be submitted to a mortgage insurer and they are currently very risk adverse.
When all of your eggs are in one basket
One of the biggest stumbling blocks when it comes to assessment of a property investment loan application is cross collateralization of securities. This occurs when you start off with one bank and one loan, then you go out and buy a second property with further funding from the same bank, who then ties the two properties together as one security; known as cross collateral.
In other words, they’re holding security for all loans across all properties. Now let’s move forward and assume you want to buy a third property. Perhaps one of your properties has increased in value, but the second has flat lined.
If you have both properties tied up in a cross collateral situation, you may not be able to access any equity at all, even though the first property has produced sufficient growth to give you a decent amount of leveragability.
Of course if the properties were not cross collateralized, you could access the equity from the property that did increase in value.
We often see this with clients who have cross collateralized securities with the big four banks. Recently a client was told that she couldn’t access more funds as the bank was not willing to increase their exposure to her. She wanted to add more properties to her portfolio, so we removed the cross collateral. As a result, she was able to purchase another five properties.
Structures for assessment success
The final consideration for investors when it comes to how banks will assess your loan application is the structure of your portfolio. The bottom line is, not all banks like to lend to every type of structure.
A good example would be the Commonwealth Bank. While they are happy to lend to a discretionary or unit trust, they are not as keen to lend to a hybrid or Property Investor Trust.
On the other hand, banks like the NAB would lend to all types of trust structures. Other smaller lenders such as AMP are pretty good with these sophisticated structures as well and have a great serviceability model.
So it is important to understand the structure you will be using, whose names will be on the loan documents and who is on title. Is the loan in individual names or in your trust name? Is the trustee company or another entity on the title? This is very important to clarify with your broker because if they don’t know what type of structure you intend to purchase your investments in, they can’t apply for the right loan and select the right bank from word go.
Essentially it’s all about getting your ducks in a row and ensuring you present the lender with an application that is impossible to reject based on their specific assessment criteria. By doing so, you have a far better chance of securing that all important finance to build a lucrative property investment portfolio and meet your wealth creation goals.
• Avoid cross collateralizing your loans.
• Use multiple banks in the right order, because that could possibly allow you to borrow enough to buy one more property.
• Buy the right type of property – one that the bank sees as a good investment.
• Maintain a good credit rating, protect your credit rating and check your credit score. Reduce your credit limit to give you more serviceability.
• Avoid multiple applications and inquiries that will impact your credit rating.
• Show a history of stable employment and stay in the same industry for a while if you can
• For the self-employed, make sure you have an ABN number.
To find out how much you can borrow or to learn more about how Metropole Finance can help you click here to book a complimentary free phone consultation.
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