Investment property financing & planning basics for investors
Real estate can be a great way to grow your money. Properties can increase in value over time (capital appreciation), and you’ll earn rental income every month.
But like any investment, it comes with its own set of challenges. The market can have its ups and downs (volatility), finding tenants isn’t always guaranteed (vacancies), and keeping the property in good shape requires ongoing maintenance costs.
The important thing is to weigh the potential benefits against the risks before you dive in. By understanding both sides of the coin, you’ll be in a strong position to decide if real estate investing is right for you.
So let’s start with the basics.
Choosing the right type of loan for your property
There’s a key decision you’ll need to make upfront: what type of loan is right for you? There are two main options: investment loans and owner-occupied loans.
Investment loans
Investment loans are designed specifically for properties you plan to rent out or resell for profit. For lenders, these loans come with a bit more risk. Since your repayment relies on rental income, factors like finding tenants and market fluctuations can make things unpredictable. To offset this risk, investment loans typically have higher interest rates and fees compared to owner-occupied loans.
Imagine you’re buying a $500,000 investment property. The interest rate on an investment loan might be 0.5% to 1% higher than an owner-occupied loan. That could mean a difference of $1,392 per year on a $400,000 loan (after a 20% down payment). But what is an Owner-Occupied Loan?
Owner-occupied loans
Owner-occupied loans are for properties you’ll be living in yourself as your primary residence. Because you’ve got a vested interest in keeping up with payments, lenders see this as a lower risk. As a result, owner-occupied loans typically come with lower interest rates and fees, making them a more affordable option.
So, which one is right for you?
The best loan type depends on your situation. So ask yourself some important questions
- Can you comfortably cover the mortgage if the property sits vacant for a while? This is especially important for investment loans.
- How much rent can you realistically expect to charge? Can it cover the mortgage payment on an investment loan?
- Are you looking for steady rental income or hoping to sell the property for a profit in the future?
By choosing the right loan and asking the right questions, you can maximize your returns while keeping risks under control.
But how do we get approval for the loan in the first place?
Loan approval process: pre-approval vs. Unconditional approval
Pre-approval is like a preliminary green light from the lender. They assess your financial health (credit score, income, debts) and give you an estimate of how much you can borrow. This effectively sets your budget boundaries for your investment property search. Now you can focus on properties within that price range and make your search more efficient and targeted. Pre-approval typically lasts 90 days, giving you ample time to find your ideal property.
Unconditional Approval is the final stage and the one you’ve been working towards. Once you’ve identified your ideal property, the lender will thoroughly review both your finances and the property details. If everything meets their criteria, you’ll receive the coveted “unconditional approval.”
Why is pre-approval important for you?
Pre-approval offers a strategic advantage, especially in competitive situations like auctions. With pre-approval in place, you can confidently bid up to your approved amount as you know your loan is likely to be finalized later. This gives you a significant edge over other buyers who haven’t secured pre-approval and might be scrambling for financing at the last minute.
Even if you secure a loan, there will be a constraint of down payment. This is one of the biggest hurdles to becoming a property owner. So what can be done?
Down payment strategies
The 20% down payment
The traditional advice is to aim for a 20% down payment as it allows you to avoid Lender’s Mortgage Insurance (LMI). LMI is like an insurance policy for the lender, not you. It protects them if they can’t repay their loan and the property sale doesn’t cover the remaining balance.
Let’s say you’re looking at a $500,000 property. A 20% down payment would be $100,000. If you can only swing a 10% down payment ($50,000), you might have to pay LMI. The cost can vary, but it could be around 2% of the loan amount. On a $450,000 loan (with a 90% loan-to-value ratio, or LVR), that could be $9,000 added to your loan or paid upfront.
Down payment options for those saving up:
Guarantor Loans: This option allows a family member to use their property as security for your loan. If you default, the lender could go after them to recover the money. This can help you borrow more than 80% of the purchase price without LMI.
- Imagine your parents agree to guarantee $50,000 of your loan for a $500,000 property. With their help, you’d only need to borrow $400,000 plus your $50,000 down payment. This keeps your LVR at 80%, allowing you to avoid LMI.
Exploring Affordable Markets: If saving a 20% down payment in a pricier area feels out of reach, consider a more affordable market. In these areas, your savings might cover a 20% down payment more easily and potentially eliminate the need for LMI.
Now since the loan type is decided, let’s also consider the interest type.
Fixed interest loans
Fixed interest loans lock in your interest rate for a set period, typically 1 to 5 years. This offers stability and predictability for your monthly payments. You can plan your finances for the long term with the comfort of knowing exactly what your monthly payment will be.
However, there’s a catch: fixed rates lack flexibility. If interest rates drop overall, you won’t benefit from that decrease. Additionally, there can be hefty fees if you decide to pay off the loan early or switch to a different loan product.
Variable interest loans
Variable interest loans, as the name suggests, adjust based on market conditions. This means your monthly payment can fluctuate up or down. While this might sound risky, it also presents an opportunity. When interest rates go down, you’ll enjoy lower rates and potentially smaller monthly payments. Variable loans often allow you to make extra payments without penalty, which can significantly accelerate your loan payoff.
So, how do you decide which loan is right for you?
- Locking in a low fixed rate is smart if rates are expected to rise.
- Fixed rates are ideal for those who prefer stability.
- Fixed rates can be beneficial when inflation is rising.
- Variable rates can save you money if interest rates are expected to fall.
- Shorter loans might make variable rates less risky.
- Diversify your interest rate exposure with a split-rate mortgage (combines fixed and variable).
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Thinking outside the bank
Traditional lenders often have rigid requirements. Alternative financing offers a breath of fresh air for those who don’t quite fit the mold, or who simply want more flexibility. Here are a few options to consider:
- Private Lending: Instead of focusing solely on your credit score, private lenders base their decisions on the property’s potential. This can be a faster and more adaptable option, but be prepared for potentially higher interest rates.
- The Power of Crowdfunding: This isa platform where multiple investors join hands to fund a property purchase. It allows smaller investors to participate in bigger projects, lowering the barrier to entry and making those dream deals more accessible.
- Partnership Investments: Sometimes, collaboration is key. Joining forces with other investors can significantly boost your buying power while spreading out the risk. Partners contribute capital and share the profits proportionally, making larger investments a realistic possibility.
- Self-Managed Super Funds (SMSFs): Ever considered using your retirement savings for real estate investment? SMSFs allow you to do just that! However, SMSFs come with specific regulations and require careful management to ensure compliance with superannuation laws.
By exploring these alternative financing methods, you can unlock a world of possibilities beyond traditional lenders. So, don’t be afraid to think outside the box – your real estate dreams might just be closer than you think!
Financial planning and budget management
Unexpected repairs, maintenance needs, or even vacancy periods can disrupt your cash flow. Having a financial buffer ensures you can handle these situations without financial strain.
Budgeting Like a Pro
- Saving for Your Down Payment: First things first – know your goal! Figure out how much you need to save for a down payment and dedicate a specific savings account for it. Consider setting up automatic transfers from your checking account right after payday. This way, saving becomes effortless!
- Expect the Unexpected: Life happens. Allocate a portion of your budget specifically for unexpected property-related expenses. This could be a separate savings account or a readily accessible emergency fund.
- Rental Rate Reality Check: Don’t just guess what your rent should be. Research your market to set competitive yet profitable rental prices. Regularly review and adjust these prices based on what similar properties are renting for. This ensures you cover your costs and generate a good return on your investment.
The takeaway
Financial planning and budget management are equally important for long-term success in property. But when in doubt, don’t hesitate to consult with financial experts! At the Investor’s Agency, we can provide personalized advice based on your unique financial situation. This professional guidance can help you make informed decisions, maximize your returns, and minimize the risks associated with property investment. So, don’t be afraid to seek help – a financial expert can be your partner in building a thriving rental property portfolio.
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