To cross collateralise or not cross collateralise…that is the question!
The structure of your loan is really important if you have a view to long term investing. You may or may not have heard of cross collateralisation or cross securitisation, however it is one of the fundamental structural concerns to get right from the outset. So what is it? Simply put, cross collateralisation is one way of loan structuring whereby one (or more) properties are used to secure the mortgage on a different property. So the borrower offers a different property than the one the loan is for as security for the lender. If you don't have your properties cross collateralised, then you will have one loan for each property. ADVANTAGES Keeping in mind that the magic number is 80, that is 80% LVR or loan to value ratio, many borrowers do what they can to keep below this figure as they don't want to pay LMI (Lender's Mortgage Insurance). The decision to not cross collateralise is often made when a borrower has equity in their existing property, typically their owner occupied property, but not enough cash to use as a deposit on a new property. The borrower is then likely to put the two properties together giving them greater borrowing capacity and reducing the risk for the lender and avoiding LMI. Another situation whereby a borrower may use this strategy is when their credit rating isn't as strong as what the banks require. The lender can reduce their risk as they have more than one property held as security. There is also slightly less paperwork involved in getting the new loan and sometimes the borrower can negotiate a better interest rate as the borrowings are higher. Now for the negatives.... DISADVANTAGES As you can see from the 'advantages', banks love cross collateralisation. It means that they have more control over your properties which reduces their risk. However, should anything go wrong with one of your loans, they have rights to all properties. Hopefully this won't be a situation you ever encounter, so let's look at other disadvantages for the astute investor. Since the lender has control over your entire portfolio, in the event that you need to sell one of the properties, the lender can dictate the terms and conditions of the sale and limit the way in which the proceeds are used. Bank policies are dynamic and the conditions under which you first had your loan approved may change by the time you try to sell. That won't usually effect the property you are trying to sell but could influence the others remaining in the portfolio. What happens if a lender changes their lending policy so that the acceptable LVR is 80% instead of 90% and one of your properties has gone down in value? Or if the lender was happy to accept 100% of rental income but will now only accept 80%? You can see how you may be forced to use some of the sale proceeds, that you thought were going down as a deposit for a new home, to service or top up your existing properties - just to satisfy the bank's policy. It also usually means that when one property is sold, the whole portfolio needs to be reassessed, which means new valuations, more paperwork and increases time and cost. Selling a property is stressful enough, surely you would want to avoid further complications. Having multiple properties can also effect your ability to negotiate the interest only terms. Generally lenders are happy to grant 5 years interest only and will sometimes allow longer terms upon request once the first 5 years is up. However, if you have more than one security with them, they may stipulate that you start paying principle and interest, to minimise their risk. The lower the LVR, the lower the risk to the bank. Changing lenders can be very time consuming if you have cross collateralised property. With more than one security there is a lot more documentation to provide. Refinancing with only one security involved usually only means obtaining valuations of the other properties to substantiate your asset position, not also providing payments history etc.. But the main disadvantage for investors is that you may be limited in your ability to access equity in a property. Where properties are cross collateralised the overall equity gain or loss is measured as a sum of every property in the portfolio. So while you may have had good capital growth in one asset, another security may have fallen in value or stalled. Therefore the gain that you thought you had experienced in one property can be severely effected by losses in another. WHAT SHOULD YOU DO? In the early stages of developing your portfolio it can make sense to avoid paying LMI and to use the equity in your first home to help buy the second, so on and so forth. However, once you really start to develop your portfolio this approach can slow you down and interfere with you investment strategy. Undoing a cross collateralised portfolio, where there are several properties involved, can be costly and take some time. So what are the next steps?
- Firstly, find a mortgage broker who really understand how to structure complex loans. Like any industry, there are varying levels of experience and understanding and the level of understanding your mortgage broker had for your first loan may not carry you through to a portfolio of loans
- Also speak to your accountant or financial advisor. Again, one who is adept at dealing with property complexity. They should also be able to help you with the most advantageous structure
- Don't be afraid of LMI - it can often be a good long term business decision and often doesn't cost as much as you think. Remember LMI protects the lender, not you
- Avoid cross collateralisation where possible, or at the very least, make sure that cross collateralisation is an informed choice and one that will provide you with the best outcome for your investment strategy
- Contact us if you would like help with your investment strategy, loan structure and more information about this and other issues that could be holding you back from realising your goals