February 27, 2014
Structuring Your Loans – Avoiding Cross Collateralising.
Brought to you by Alan Heath of Mortgage Choice Brisbane CBD. Home Loan specialist for the everyday you.
The term cross collateralise means that one loan uses two properties as security. Why might this happen and why should you avoid it?
You have decided to buy an investment property. Your owner occupied residence is worth $500k and your home loan is now only $250k. You have what is called equity in your home. The usable equity is the available equity that a bank will lend against. For this example let’s also stay under 80% to avoid mortgage insurance. This means you can take your borrowing against the home out to $400k giving $150k of usable equity.
The investment property is $500k. For simplicity sake, lets say that the purchase costs are being taken care of with cash. Therefore you need a loan total of $500K. However, a bank will not lend $500k against a house cost of $500k.
A common example outcome from a bank conversation: “You’d like to buy an investment property? – certainly. You’d like to borrow 100%? – certainly. Here is your loan for $500k” It all seems so simple. You have a home loan for $250k and an investment loan for $500k. You have two houses. What’s the catch?
The catch is in the loan documents and most people don’t even spot it because it seems so “natural”.
Your $250k home loan is secured by your owner occupied house, but the bank has used BOTH houses as security for the $500k investment property loan. You will find TWO addresses in the $500k loan documents. This loan has been “cross collateralised”. Total borrowings are $750k; total value is $1000k.
What’s the problem? The problem is that the bank has structured this to its own benefit and its own protection at your expense. The problem is that you have voluntarily handed complete control to the bank for your own future choices. Future choices that include not just your investment property, but your owner-occupied “home” as well.
Take two examples;
- You have decided to become self-employed, and need to find start-up capital.
- You have had a new baby and need to take extended maternity leave on half pay.
In each scenario, you would like to sell the investment property, using the profit for either the business start-up, or income to support extended leave. Despite still receiving income that covers your living and business expenses, in both cases banks will “assess” your income as zero. Herein lies the problem.
To sell the investment property, which is cross collateralised with your owner-occupied home, you will need to fill in a form for a “partial discharge”. This is where you request PERMISSION to be able to retain borrowings against the house that is not being sold. The bank will assess your ability to keep the remaining loan (for your owner-occupied) with a full loan application based on your CURRENT earnings (which they count as zero). They can decide to deny your request and decline the application, forcing you to sell BOTH properties. This is not to say they will – BUT why would you give a bank this heavy handed and totally unnecessary position of power.
So how can you avoid this eventuality and still use the equity in your owner-occupied to purchase an investment property?
We still wish to borrow $500k for the $500k purchase. We borrow $400k using only the investment property as security. We can even do this with a different bank if that bank has a better product for the investment loan.
We then take a separate loan for $100k and secure it against your owner occupied. You now have your owner occupied with a $250k home loan and a $100k investment loan against it.
The difference is that you have control – over lender, product and future decisions. You can choose a different bank every time you purchase WITHOUT having to leave your owner occupied bank. The bank that has the best owner occupied product for you may not be the one with the best investment product! Just because one shop has the suit or dress you want, doesn’t mean that another shop mightn’t be the best place for shoes. You would never give one retailer all of your current and future business with the power to veto future decisions as well. Why on earth would you accept this behaviour from a bank??
Some finer points:
- Yes you now have three loans – which means two direct debits for the investment property. Yes it may appear more complicated but it is in fact simpler. If you need or wish to sell a house then the loans against that house clear to zero in a “full” discharge. The other house is not involved. The bank does not need to, and in fact is unable to make an assessment about the other property. Quite correctly – it is none of their business what you do with your money and what decisions you make.
- How can a loan against the owner occupied property be an “investment loan”? An important principle is called the “purpose test” The purpose of the $100k loan is to purchase the investment property. The property it is secured by is not relevant. Of course you need to check this with your accountant – but that is because I have to say that in a blog. Your accountant will agree with this point.
- Some people baulk at this structure saying that “they don’t want to involve the family home”. To even say this means they have not understood at all what the bank is doing with the cross collateralised loan. In my scenario only $100k of the investment purchase is secured by your home, $400k is secured by the investment. In the banks scenario the whole $500k is secured by your owner occupied and the whole $500k is secured by the investment – how is that for overkill!!
What I am going to say next is not a criticism – it’s just the way it is. An employee of a bank must act in his or her employer’s best interests The primary message here is that you need a mortgage broker that acts in your best interests.
Let me help you make your money work harder for you and keep your futures in your hands.
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