finance

Loan structure – demystified

Preer | September 8, 2016

Many investors wonder how they will ever build a property portfolio when they’ve been told they can’t access any more equity by their lender.

You would be surprised how many times people come to us with these same questions and don’t realise that often the loans they took out are causing some of the problems and holding them back from building a sizeable portfolio.

So how does this happen?

The first thing to remember is that banks and your mortgage brokers are not in the business of investing in properties or minimising your tax. Their job is purely to sell you a product.

Many hard working Australians’ property dreams are shackled by the loan structures their lenders have provided. Without an overall vision of your entire property portfolio, a short sighted broker can process a single loan that will derail your future purchases.

When it come to financing, most people only cares about interest rate. However, in reality, interest rate should be the last thing you worry about. Your ability to expand your property portfolio hinges on how well you structure your loans. A loan structure will influence many things including the interest rate and fees you pay, the amount of tax that you pay, the amount of flexibility you have, your access to additional finance (i.e. your ability to invest more) and so on.

What is loan structuring? 

There are three primary areas in which a loan and its underlying asset can be structured.

  • the actual loan type
  • asset ownership structure
  • how equity in existing properties is utilised

Having the correct loan structure in place can not only increase the tax effectiveness of your loans and help protect your assets but also can make restructuring your loans when your circumstances change easier.

1. Choose the right loan type

Should you go for a line of credit, an interest only loan, a loan with a 100% offset account, a plain old principle and interest loan or something else?

The truth is for the most simple of borrowing situations it probably doesn’t really matter that much. However once your affairs become more complex or you are planning to acquire multiple properties in the future it does start to matter. This is where some good advice upfront can potentially save you many thousands of dollars in the future.

Many times we see borrowers, other brokers and bank managers focussing their energies on the specifics of a loan itself such as small differences between lenders fees and interest rates. Instead they should be looking at the bigger picture first then the product second.

loan structure

Sometimes, choosing the right product can save you up to 20 years of interest payment and that’s considerably more than a potentialy small difference in interest rate between two loans. That is not to say that you can’t get both the right product and the best rate,  however it pays to keep focussed on ones strategy first not the best rate offered today.

2. Loan structuring for asset protection

Many self-employed borrowers in highly litigious industries should consider the best structure to purchase a property in to protect their asset.

Example 1 – Title in one name for a husband and wife scenario

If borrowers are a husband and wife or a de facto couple, and only one is self employed in a highly litigious industry, then often the best ownership structure would be to have the party that is not involved in the business as the sole owner of the property. The loan could then be set up in joint names if allowed by the chosen lender, or if not allowed the non-owner could act as a guarantor for their partner if needed.

Example 2 – Owning via a trust

A trust is an arrangement which allows a person or company to own assets on behalf of another person, family or group of people. These people are known as the beneficiaries of the trust. Assets are owned on behalf of “beneficiaries” and are controlled by a “trustee” who can be either a corporation or a natural person. The trustee is governed by a “trust deed” which sets out the rules that the trustee must follow. It also covers how profit is distributed to the beneficiaries.

If a borrower is single or both partners are involved in high risk industries then perhaps a trust structure would be worth considering. There are a few different types of trusts, but not all are accepted by lenders. If you don’t have a trust set up yet, we recommended you go with a family trust (this is a type of discretionary trust). This is the most common and widely accepted trust by lenders. To fully protect yourself we recommend you opt for a corporate trustee (however seek advice). Below is an example of the loan structure for a family trust.

“Paul Smith owns a domestic construction business. His industry is notoriously litigious due to work sites in general being dangerous places. Paul is single and looking to buy a home for himself. Paul sees his accountant and sets up a family trust and a new special purpose company that is to be trustee for his family trust. Paul is the sole director and shareholder of the trustee company.

Owner / mortgage holder: Paul Smith Pty Ltd (as trustee for The Smith Family Trust)

Borrower: Paul Smith Pty Ltd (as trustee for The Smith Family Trust)

Guarantor: Paul Smith”

There can be variations on this, where the borrower is the individual and the guarantor is the trustee company. There may be some tax advantages if set up this way and the property is an investment.

However the more complicated the trust or structure the less lenders will be willing to do the loan for you. They need to be clear on how and from whom to get their money back if there is a problem.

3. Loan structure for growing portfolio 

Most investors use the equity in one or more properties to allow them to purchase another. We believe that great care should be taken in how these loans are structured, especially in relation to cross collateral.

What is cross collateral?

Cross collateralisation is the term used to describe when two or more properties are used to secure one or more loans by the same lender. When you have loans cross collateralised, the lender in question is securing the aggregate of all your borrowings with the aggregate of all your security.

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For example,  you have a home loan of $400,000 which is secured by your family home worth $800,000. Potentially you could use the equity in your home as additional security and purchase an investment property for say $500,000 while borrowing the entire purchase price and the associated costs such as stamp duty. So say a total loan of $530,000.

In aggregate you would have $930,000 in loans secured by $1,300,000 worth of property. Expressed as a loan to value ratio (LVR) it would be 71% which would be an acceptable level for all lenders.

At first, the above solution might seems to work out. However, in reality, it is very detrimental to growing your portfolio.

As an example, say an investor has 5 properties all tied together as security for various loans and decided to sell one of their properties. Lenders can require the following to happen.

  • The other 4 remaining properties would have to be valued to see if the security for the remaining loans will be sufficient. If it wasn’t, the lender can demand all sale proceeds be used to reduce the overall debt. In extreme cases a lender may even not allow the sale to go through.
  • Some lenders require a full reassessment of a borrower’s financial position to see if they can still afford the remaining loans. This can come at an inconvenient time for the borrower. If the remaining loans are not affordable according to the lender, they can as above demand the entire sale proceeds are used to reduce the overall debt level. In extreme cases, if the lender takes the entire sales proceeds and they are still satisfied that the remaining loans fit within their policy, it may trigger a default. In this case a lender could force a borrower to repay all their loans immediately. In practice this would mean having to liquidate their entire property holdings, including possibly the family home, or repay the debt in full by refinancing to another lender (which might not be possible).
  • Most lenders will require new loan and mortgage documents to be issued. While this in itself is no big deal it can be a hassle!

We always recommend that our clients do the stand alone method if possible.  The reason for this is that untangling a series of crossed collateralised properties can be very difficult. It can also mean the borrower loses control of their affairs and can expose them to unnecessary risk.

By keeping all properties as stand alone, the investor can sell any property at any time and pay out only the loan or loans secured by that particular property. There is no need to complete a reassessment of your “position” with the lender, and also no need to do valuations on the remaining properties. Importantly, the investor dictates what happens to the net sale proceeds.

The key to avoiding the glass ceiling imposed by most banks is laying out the terms that you want. I’ve learned over the years that it’s best to shop lenders against each other. They may sound quite harsh but remember…

“They don’t make money unless they are selling it”.

Use this as your lever when offering your business. Most investors have it all wrong when they approach a lender. They hold out their hat and hope the bank is going to lend the money.

Insure your position and locate a savvy finance broker that’s skilled with lending and knows where you are headed long term. Don’t take their word for it, interview and qualify their credentials. Ask for some clients that you can speak to and verify they have the ability. Also make sure they are well versed with plenty of lenders. Meaning they can place your requirements with multiple lenders to find the right one that won’t cross-securitise.

This allows you the flexibility to keep borrowing where you need to – the early part of your accumulation cycle.

Finance is one of the most integral parts of a strong and fast portfolio, one of the best ways to give you the strongest position to be able to shop your purchase around. As with many of the different strategies and variations discussed, be sure to create some solid value on the way into the deal. This way you’ll find a lender far more supportive because they know they’re dealing with a sophisticated investor capable of creating value. Not just approaching a lender with the “hope” of picking up anything.

I hope this post can at least give you some ideas around loan structures and start to see why only 2% of our population own 4 or more properties.

If you need further help or need more information on what’s the best loan structure for you, here’s the good news…

At PREER, we are constantly working with and are able to access a pool of real talent in the field of property finance. They are highly skilled property finance strategists who can help you make the most intelligent decisions when purchasing your next high growth acquisition.

The only aim of our financing team is to work alongside you long term with the goal of expanding your portfolio to ensure your retirement is secure and prosperous. Ensure you have a committed, expert team on your side to guide you through not just one property purchase, but a lifetime of lending.

If you want to learn how to escape the glass ceiling imposed by your bankers and would like to find out how you too can continuously growing your portfolio via a cleverly structuring your loans, I urge you to send an email to hello@preer.com.au and request a 30 minutes free consultation with one of our financing team today.

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