Pros and Cons Of Using Equity To Buy Properties

Discussion in 'Property Finance' started by Tyrones, 9th Jun, 2015.

  1. Tyrones

    Tyrones Member

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    Hi SS members,

    My wife and I are in the process of looking to build up our portfolio of properties and currently own 1 investment property that has equity to draw down from.

    I would like to get some feedback and honest opinions on the pros and cons of using say 10% equity compared to say 50% equity as deposits for investment properties.

    What I'm confused about is if:

    We have equity of $100K and we use it for the following scenarios:
    1. 10% deposits using 100K would allow me to purchase $1million worth of properties compared to
    2. 50% deposit using 100K would allow me to purchase a $200K property.

    After speaking to some family members they are recommending us to put down 50% equity instead of say 10%.

    Essentially wouldn't I be borrowing 100% of the total amount anyway, since I have to pay interest on the equity (deposit) and the new loan as well? Is that how other property investors are able to buy multiple properties?

    What are the risks involved?

    Appreciate any comments and opinions.

    Thank you
    -Tyrone
     
  2. thatbum

    thatbum law talking guy

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    Why would your family members tell you to use 50% equity to purchase? What possible reasoning would they have?
     
  3. Jamie M

    Jamie M Mortgage Broker - Oz Wide

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    Hi Tyrone

    It all comes down to your strategy and risk tolerance.

    If you're looking to buy multiple properties quickly - then you'll need to go down the smaller deposit route. You'll be up for some LMI but that's not the end of the world - it enables you to buy more with less.

    Having said that - your $100k isn't going to buy you $1m worth of properties in this current lending environment. You should really be aiming to contribute a 12% deposit plus costs towards each IP. Costs generally run at around 4% of the purchase price.

    Cheers

    Jamie
     
  4. Corey Batt

    Corey Batt Finance Broker

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    There's strong arguments on 20% vs 10% deposits due to LMI usage to leverage further, but anything further than that is just artificially limiting your portfolio growth without strong reasoning.

    And it's not even a case of using one strategy the whole way through - you may find that initially to grow your portfolio you may utilise LMI effectively to expand your reach, but as your portfolio matures you have sufficient equity to grow whilst still providing 20% deposits on each.
     
  5. Tyrones

    Tyrones Member

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    They are worried that we would be putting not enough money into the property and would be risking too much if the market goes down.

    Their reasoning is to reduce the risk involved. I'm still trying to figure out their reasoning as well, and that's why I wanted to get further opinions and see what others have successfully achieved.

    Also they own 3 properties including PPOR in USA.
     
  6. albanga

    albanga Member

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    Welcome Tyrones,
    Your family is not giving you the best advice IMO.
    Using equity really depends on where you are in your acquisition phase and also how aggressive you want to be. Given you are just beginning I imagine a more aggressive approach is going to be the ticket and that will involve purchasing at 90% LVR and paying LMI.

    Keep in mind though when you say 100k in equity that may not be "useable" equity. Banks will lend to 80% LVR and after that point you will need to pay LMI. If you paid some already then it will only cost you a slight adjustment but otherwise this can be very pricey.
    A simple example is your loan amount may be 400k and the property is valued at 500k. In this scenario you actually have $0 in useable equity (400,000 loan amount / 500,000 property value * 100 = 80%LVR).
    What you would do in this scenario though is take the LVR up to 90% which would give you access to 50k in equity and then you just add the LMI into the loan.

    Start with seeing a broker, there is plenty on these forums who will be able to best guide you.
     
  7. Tyrones

    Tyrones Member

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    Thanks Jamie. So realistically a deposit of 16% would be the best way to leverage in this current market?

    And this allows us to buy more properties? At what stage would I be starting to pay these off if I set them up as IO loans?
     
  8. Rolf Latham

    Rolf Latham Member

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    analyse from outside.................

    why is it lower risk to throw 150 % more cash into a property deal than to keep it as a liquid cash in an offset account ??

    There can only be one reason....... fear of the 30 % being burnt on doo dads. Any other idealogy is just plain silly, though im waiting to learn, my red nose, wig and big shoes need another work out.

    ta
    rolf
     
  9. see_change

    see_change Apprentice Timing Lord

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    Keeping equity in reserve so you have it available in case of a crisis is , IMHO , a better safety net .

    If things go pear shape , having available money gives you breathing space and time to move .

    Cliff
     
  10. Gockie

    Gockie Life loving Big 4 Banker

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    Another SS member with not too investment savvy parents. Welcome to my club!
    The U.S. is different to Aus when you consider taxes etc. Your parents may have that point of view which may work in the U.S. (Not sure) but throwing a 50% deposit... Nope. Remember to use OPM.... That's the power that property investing has and is the key to building great wealth. (Use that with the power of time)...
     
  11. Rixter

    Rixter $uper Investor (Retired)

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    Exactly same philosophy as myself.

    I have never gone over 80% LVR for the exact risk management reasons provided above.

    No matter what asset class investment you're into one should always be looking to maximise cash flow and minimise risk where ever possible.
     
  12. Brady

    Brady Big 4 Banker

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    Best to minimise deposit and maximise cash flow, far safer IMO. Gives you the control rather then the bank. You can still offset the loans to reduce interest but preserve your funds to use as you please.

    What LVR you chose is a personal choice pending your risk appetite, personally I've been borrowing at 90% (but I get LMI waived at that level). Often find that people will borrow at low LVR early and then later want to borrow higher, it's easier the other way round. Best thing is to look at what you're hoping to achieve.

    Something that's stuck with me from here, don't remember who it was... If you're not going to make money from a property purchase in the first two years then don't. This can be from either CG or CF even better both. To me any cost associated like LMI would be outweighed by the benefits of the purchase.

    Also having a nice cash buffer gives a good SANF, I like 6 months of interest repayments over my whole portfolio.
     
  13. Tyrones

    Tyrones Member

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    Totally agree - I'd rather have money that's not tied up and not buy more doo dads!
     
  14. Tyrones

    Tyrones Member

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    Thanks Brady - that's a very good money management idea. I'll keep that in mind and won't be maxing ourselves out.
     
  15. Tyrones

    Tyrones Member

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    Thank you for everyone's feedback and opinions. I thought I'd share this with you as it's another opinion:

    "First, if the market turns against you, so much so that your equity falls below a certain amount or even go negative, whether the bank has the right to "call in" the loan. Second, if you fail to pay the monthly service and the bank took over the property, whether or not you are still on the hook if the bank did not realize sufficient funds from your property to cover the balance. In either of these cases, the result may be disastrous.

    While we are talking about the market turning against investors, I found one extreme example in Spain. I was in a meeting a few days ago in Alicante, which is a small coastal Mediterranean town in Spain. There I was told that, even eight years after the financial crisis, some beach front properties are now selling for less than 25% of what they use to fetch. Of course, Spain has relatively extreme problem of over-building and being trapped in the Euro. But it is still something to think about."


    I'm guessing family wants to protect us from making bad decisions that may have happened to them and that's why they provide the worst case scenario...

    Also maybe my relatives are thinking that we would be cross collateralizing, that's probably why they could be saying put in 50% deposit..

    What are everyone's thoughts on this?
     
    Last edited: 10th Jun, 2015
  16. Jamie M

    Jamie M Mortgage Broker - Oz Wide

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    Yep - that allows enough for a 12% deposit plus costs.

    Lots of banks are reducing their IP loans to 90% (which is pretty much 88% + LMI added on top).

    88% is generally the sweet spot for LMI too (it's less costly compared to 90%) and credit scoring is usually less harsh as well.

    Cheers

    Jamie
     
  17. LeoT

    LeoT Member

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    It all comes down to 2 things:

    1. Goals and timeframes/level of aggression
    2. Risk tolerance

    That's it.

    If you want to build a portfolio asap AND your risk tolerance is moderate, there is absolutely no good enough reason to go 20%. The less the better.
     
  18. JohnHenry

    JohnHenry Mister

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    Does the bank can actually do "margin call" if the property equity to secure the next IP goes down due to economic downturns ?
     
  19. Rixter

    Rixter $uper Investor (Retired)

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    I'm not aware anyone would purchase a property using a margin loan other than purchasing shares.
     
  20. JohnHenry

    JohnHenry Mister

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    Neither do I Rick.
    That's why I ask here, is there any similar situation where the bank would do similar thing to ask the customer to pay up any shortfall when the investment values somehow depreciates.