Reply: 2.1.1.1.1.1.1
From: Michael G
Hi,
Okay the fundamental thing you need to understand about borrowing are the terms "security" and "collateral" which are basically the same for this discussion.
Banks will lend you any amount of money for pretty much anything, as long as their risk is pretty much zero.
How do they reduce risk and protect themselves?
Well they do this by holding something in return for lending you money.
This something is called "collateral" which the banks take as "security" to cover their risks.
Now the thing to keep in mind is that lenders want ZERO risk. That means, if you default on the loan, the banks want some want to recover their money. They do this by selling off your security.
For investors this is normally property. Lenders aint a patient lot either, so they want they cash ASAP. So your "collateral" will be auctioned in a fire sale.
Now the lenders know this from the start, so they lend based on the value of your property in such a sale. Which is why the value it lower than FMV (fair market value) most of the time (especially when the market is flat).
Another thing is they want to ensure that their loan PLUS their selling costs are covered.
What does this mean?, well selling costs are maybe 5% of the value of the property and if they have to sell in a hurry then they may need to sell 10% below market.
This totals 15%, so they want to ensure that your "collateral" will cover the loan + 15%.
So on our $100k property, you have to come up with at least 15% (which is the deposit).
This ratio between the money they will lend and what you have to pay out is called the LVR (loan to value ratio).
Lenders by default have LVRs of 80%. Which gives them 20% cover of all their costs above and beyond the loan.
You can borrow higher, but you need to take something called mortgage insurance.
This is a policy which you pay for that protects THE LENDER, NOT you.
What happens is if you default, the banks sells your property, if they lose out, they claim against their mortgage insurance policy. The insurer pays the bank their difference. THEN THE INSURANCE COMPANY COMES AFTER YOU FOR THE MONEY.
And LVRs change depending on where you buy and what you buy.
Rural, metro, residential, commercial, its all different.
So if you have "equity" (the difference between what you owe and the value) in a property a lender will take this "collateral" and use it as "security" so that the total LVR (loan to value of properties) is below their limit.
This is a simple calculation of adding up the value of all your property and dividing it by the total amount of all your loans.
The reason why the banks want you to refinance is simple. They want you to pay THEM the interest payments, not you competitors. Also if you cross collaterise, lenders dont like being second in line when you default. But this is a difference case with LOCs (line of credit)
Why?, well LOCs typicaly have an lVR of 80% which means you can draw down money up to 80% of the value of your property.
A LOC is line a big credit card. Interest is calculated daily based on the outstanding debt. Quite often LOCs are even accessed by credit cards anyway. The danger with LOCs are that people buy DOODADs with the money and not assets. So they rack up debt for cars and holidays and not into stuff which actually HELPS them pay back the debt.
With an LOC you can draw down the money and because its CASH you can use this anywhere. Even for a deposit on a loan from another bank. The 2nd lender doesnt care where the money came from because if you default is has this cash to recover with. Its the 1st lenders problem whether you pay back your LOC debt or not.
So with an LOC you can draw down and take out loans with anyone. But if you have to put up your equity as security (cross collaterise without an LOC) then you will more than likeley have to do it all with one lender.
And why do people like LOCs, besides the higher cost of interest (which is an opporunity cost), investors are free to borrow from different banks.
You see besides everything else, lenders get nervous when you borrow too much from them, the unspoken limit is around 5 properties. Once you have 5 properties with a lender, borrowing more becomes difficult, not because of the deal you present, but because of their internal policies. So with an LOC you can draw down, and just borrow from somewhere else, with the need to refinance all the time.
How's that?, does that info help?
Michael