Refinancing your home loan to buy an investment property

If you have been paying down your mortgage consistently while living in your property, you may be considering using your available equity to secure an investment property. While this strategy comes with its risks, there is also great reward to be had in a successful investment.

Of course, there is no point in diving into an investment which you can’t afford that may leave you in over your head. There has to be a balance between the risk you take on and the potential upsides. Reducing your outgoing expenses, so that you free up more income, can be one strategy to reduce the risk of taking on more debt. One way of doing this could be to refinance your existing home loan to a lower interest rate to use the monthly savings to put towards paying off your investment property.

Before you get to this point, however, taking the time to ask yourself some tough questions and get all the right information is the best place to start.

Can you afford it?

The first question to ask yourself should be if you can afford to take on more debt and how it will affect your life if you do. Take the time to work out the answer to this question carefully, as taking on debt that you can’t comfortably afford will have serious implications for your financial situation.

First, look at the amount of useable equity you have in your current property and see if this will be able to serve as a deposit for the investment. You should ideally have 20 per cent of the investment property’s value as a deposit. This size deposit means that you will avoid lender’s mortgage insurance and reduce the bank’s concerns about the potential risk of taking on more debt.

What is useable equity?

Useable equity is around 80 per cent of the value of your property minus any debt still owing. Lender’s won’t usually allow you to borrow the full value of the property in case market prices drop and your loan ends up bigger than the value of the house.

How to calculate:

If your property value is = $880,000

And your current outstanding debt is = $300,000

$880,000 x 0.8 = $704,000

$704,000 – $300,000 = $404,000

Useable equity = $404,000

 

Equity isn’t everything, however, as you will also need to have sufficient income to service both home loans. This means that your income will need to be able to pay both loans and still meet your everyday living expenses which the bank will closely examine. Keep in mind that if you have other credit in the form of personal loans, car loans and credit cards, this will reduce your borrowing capacity. This is why it may be a good idea to refinance your existing owner-occupier loan to a lower rate to free up some extra cash to add to your useable income.

If you are still in the early stages of determining whether you can afford an investment property, then you should use a mortgage calculator to estimate what your monthly repayments would be. Once you have an estimate of how much you will need to borrow, and at what interest rate, you can mock up what your monthly repayment schedule will look like and see how that would fit into your current budget.

After you use the calculator to determine how the repayments will fit into your budget, you need to also factor in an emergency savings buffer. This should be the deciding factor in whether you can afford an investment property. If you won’t have spare cash to put aside for an emergency, such as unplanned time off work, then the potential consequences if you lose your income for a period of time can become catastrophic; from losing your investment property to losing the roof over your head. You should be able to put aside enough cash to cover repayments on your owner-occupier loan and investor loan for at least three months to guard against a situation such as this.

EXAMPLE – Yusuf looks to invest

Yusuf and his wife Semira have been paying off the house they live in for ten years and have built up enough useable equity to make up a 20 per cent deposit on an apartment for an investment property. The apartment is close by and could potentially also be used by the couple’s children in the future or their parents as they get older. In the meantime, the apartment has two bedrooms, a car spot, is close to shops and has a train station nearby.

Yusuf believes they will have no trouble renting it out to help with the monthly repayments. Yusuf heads online to use a mortgage calculator to see how much his home loan repayments will cost each month if he refinances to a larger loan. Yusuf sees that even though the monthly repayment size will increase significantly by refinancing to a larger loan size, the couple’s combined income and the potential rental income could still cover the payments with enough money to spare for comfortable everyday living.

With a further $20,000 stashed away in savings, Yusuf judges that he will also be covered for emergency situations in which he cannot make mortgage repayments for a few months. Yusuf believes he may be in a good position to invest, however, he decides to get some professional financial advice before he commits to taking on more debt.

 

What benefits will you get?

Taking on the added debt of an investment property would hardly be worth it without the benefits you expect to gain from the property. It is important to keep in mind that these benefits come from keeping the property long term and the potential increase in property value. The initial years of your investment will most likely see you run your property at a loss. In this situation, you may be able take advantage of negative gearing and claim your losses against your income for tax purposes.

Rental income is another potential benefit of having an investment property and can be crucial to many people’s investment plans. If you are planning on renting out your property, then getting a rental estimate letter from the real estate agent who currently looks after the property will give you an idea of the potential rent you could earn. Making your own assessment or getting a professional opinion as to the desirability of your potential investment property’s location for renters is also advisable. You don’t want to have the hassle of constantly looking for new tenants to fill your property, especially if the rental income is a big part of your loan repayment plan.

What are the risks?

With every investment there comes a level of risk. Your lender will play a big role in assessing the amount of risk you are taking on by borrowing for an investment property and many different factors will be taken into account. Potential risks include property value growth being less than expected over time or defaulting on your loan due to a lack of income.

Defaulting on your loan can be caused by many, often unpredictable, lifestyle factors, including loss of income, or external factors such as reduced rental desirability in the area of your investment. These risks need to be factored in to your decision before you take on more debt. The more back-up plans you can have in place, like an emergency fund, investments in other assets and diverse income streams, the more secure you will be if something does happen to go wrong.

There is also a chance of being rejected on your refinancing application if the bank deems the amount requested to be too high risk. This can damage your credit score which can have long term implications for your borrowing capacity.

Ready to commit

Young couple sitting on the floor and looking at the blueprint of new home.

If you do decide you want to purchase an investment property, you will need look for investment loans that will suit your needs. Having a loan pre-approved before you begin looking for a property will give you the confidence to go in and bid confidently on properties you may be interested in.

Investment property home loans 

At this early stage of your loan search, you have the choice of remaining with your owner-occupier lender for your investment loan as well or shopping around for the lowest rates on the market. If you have a sizeable deposit and a secure income, chances are that multiple lenders will be interested in your business meaning that you can look for competitive interest rates.

Shopping around for a good rate also gives you an opportunity to consider which features you have been using with your current home loan and which features you would like in your investment loan. For example, if your current loan caps the amount of extra repayments you can make per year, then you may wish to find one that will allow you to make unlimited extra contributions. Alternatively, you may wish to find a loan that gives you fee-free access to a redraw facility or offset account.

While you are researching and comparing investment loans you will likely get a good idea of what the mortgage market is currently offering in terms of owner-occupier loans as well. If your current home loan rate does not seem to be competitive then this is a great chance to consider refinancing your existing loan to reduce the size of your monthly repayments and increase your useable income.

Even though refinancing your loan will most likely come with some initial costs, and require your time in the research and application phase, a switch to a low rate lender will generally save you money in the long run.

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Learn more about home loans

What is an investment loan?

An investment loan is a home loan that is taken out to purchase a property purely for investment purposes. This means that the purchaser will not be living in the property but will instead rent it out or simply retain it for purposes of capital growth.

What is a line of credit?

A line of credit, also known as a home equity loan, is a type of mortgage that allows you to borrow money using the equity in your property.

Equity is the value of your property, less any outstanding debt against it. For example, if you have a $500,000 property and a $300,000 mortgage against the property, then you have $200,000 equity. This is the portion of the property that you actually own.

This type of loan is a flexible mortgage that allows you to draw on funds when you need them, similar to a credit card.

What is equity? How can I use equity in my home loan?

Equity refers to the difference between what your property is worth and how much you owe on it. Essentially, it is the amount you have repaid on your home loan to date, although if your property has gone up in value it can sometimes be a lot more.

You can use the equity in your home loan to finance renovations on your existing property or as a deposit on an investment property. It can also be accessed for other investment opportunities or smaller purchases, such as a car or holiday, using a redraw facility.

Once you are over 65 you can even use the equity in your home loan as a source of income by taking out a reverse mortgage. This will let you access the equity in your loan in the form of regular payments which will be paid back to the bank following your death by selling your property. But like all financial products, it’s best to seek professional advice before you sign on the dotted line.

Mortgage Calculator, Loan Purpose

This is what you will use the loan for – i.e. investment. 

How much money can I borrow for a home loan?

Tip: You can use RateCity how much can I borrow calculator to get a quick answer.

How much money you can borrow for a home loan will depend on a number of factors including your employment status, your income (and your partner’s income if you are taking out a joint loan), the size of your deposit, your living expenses and any other debt you might hold, including credit cards. 

A good place to start is to work out how much you can afford to make in monthly repayments, factoring in a buffer of at least 2 – 3 per cent to allow for interest rate rises along the way. You’ll also need to factor in additional costs that come with purchasing a property such as stamp duty, legal fees, building inspections, strata or council fees.

If you are planning on renting the property, you can factor in the expected rental income to help offset the mortgage, but again it’s prudent to add a significant buffer to allow for rental management fees, maintenance costs and short periods of no rental income when tenants move out. It’s also wise to factor in changes in personal circumstances – the typical home loan lasts for around 30 years and a lot can happen between now and then.

What is a loan-to-value ratio (LVR)?

A loan-to-value ratio (otherwise known as a Loan to Valuation Ratio or LVR), is a calculation lenders make to work out the value of your loan versus the value of your property, expressed as a percentage.   Lenders use this calculation to help assess your suitability for a home loan, and whether you need to pay lender’s mortgage insurance (LMI). As a general rule, most banks will require you to pay LMI if your loan-to-value ratio is 80 per cent or more.   LVR is worked out by dividing the loan amount by the value of the property. If you are looking for a quick ball-park estimate of LVR, the size of your deposit is a good indicator as it is directly proportionate to your LVR. For instance, a loan with an LVR of 80 per cent requires a deposit of 20 per cent, while a 90 per cent LVR requires 10 per cent down payment. 

LOAN AMOUNT / PROPERTY VALUE = LVR%

While this all sounds simple enough, it is worth doing a more accurate calculation of LVR before you commit to buying a place as there are some traps to be aware of. Firstly, the ‘loan amount’ is the price you paid for the property plus additional costs such as stamp duty and legal fees, minus your deposit amount. Secondly, the ‘property value’ is determined by your lender’s valuation of the property, not the price you paid for it, and sometimes these can differ so where possible, try and get your bank to evaluate the property before you put in an offer.

What is an interest-only loan? How do I work out interest-only loan repayments?

An ‘interest-only’ loan is a loan where the borrower is only required to pay back the interest on the loan. Typically, banks will only let lenders do this for a fixed period of time – often five years – however some lenders will be happy to extend this.

Interest-only loans are popular with investors who aren’t keen on putting a lot of capital into their investment property. It is also a handy feature for people who need to reduce their mortgage repayments for a short period of time while they are travelling overseas, or taking time off to look after a new family member, for example.

While moving on to interest-only will make your monthly repayments cheaper, ultimately, you will end up paying your bank thousands of dollars extra in interest to make up for the time where you weren’t paying off the principal.

Will I have to pay lenders' mortgage insurance twice if I refinance?

If your deposit was less than 20 per cent of your property’s value when you took out your original loan, you may have paid lenders’ mortgage insurance (LMI) to cover the lender against the risk that you may default on your repayments. 

If you refinance to a new home loan, but still don’t have enough deposit and/or equity to provide 20 per cent security, you’ll need to pay for the lender’s LMI a second time. This could potentially add thousands or tens of thousands of dollars in upfront costs to your mortgage, so it’s important to consider whether the financial benefits of refinancing may be worth these costs.

How do I calculate monthly mortgage repayments?

Work out your mortgage repayments using a home loan calculator that takes into account your deposit size, property value and interest rate. This is divided by the loan term you choose (for example, there are 360 months in a 30-year mortgage) to determine the monthly repayments over this time frame.

Over the course of your loan, your monthly repayment amount will be affected by changes to your interest rate, plus any circumstances where you opt to pay interest-only for a period of time, instead of principal and interest.

How do I refinance my home loan?

Refinancing your home loan can involve a bit of paperwork but if you are moving on to a lower rate, it can save you thousands of dollars in the long-run. The first step is finding another loan on the market that you think will save you money over time or offer features that your current loan does not have. Once you have selected a couple of loans you are interested in, compare them with your current loan to see if you will save money in the long term on interest rates and fees. Remember to factor in any break fees and set up fees when assessing the cost of switching.

Once you have decided on a new loan it is simply a matter of contacting your existing and future lender to get the new loan set up. Beware that some lenders will revert your loan back to a 25 or 30 year term when you refinance which may mean initial lower repayments but may cost you more in the long run.

What is equity and home equity?

The percentage of a property effectively ‘owned’ by the borrower, equity is calculated by subtracting the amount currently owing on a mortgage from the property’s current value. As you pay back your mortgage’s principal, your home equity increases. Equity can be affected by changes in market value or improvements to your property.

How much are repayments on a $250K mortgage?

The exact repayment amount for a $250,000 mortgage will be determined by several factors including your deposit size, interest rate and the type of loan. It is best to use a mortgage calculator to determine your actual repayment size.

For example, the monthly repayments on a $250,000 loan with a 5 per cent interest rate over 30 years will be $1342. For a loan of $300,000 on the same rate and loan term, the monthly repayments will be $1610 and for a $500,000 loan, the monthly repayments will be $2684.

Who has the best home loan?

Determining who has the ‘best’ home loan really does depend on your own personal circumstances and requirements. It may be tempting to judge a loan merely on the interest rate but there can be added value in the extras on offer, such as offset and redraw facilities, that aren’t available with all low rate loans.

To determine which loan is the best for you, think about whether you would prefer the consistency of a fixed loan or the flexibility and potential benefits of a variable loan. Then determine which features will be necessary throughout the life of your loan. Thirdly, consider how much you are willing to pay in fees for the loan you want. Once you find the perfect combination of these three elements you are on your way to determining the best loan for you. 

What is a guarantor?

A guarantor is someone who provides a legally binding promise that they will pay off a mortgage if the principal borrower fails to do so.

Often, guarantors are parents in a solid financial position, while the principal borrower is a child in a weaker financial position who is struggling to enter the property market.

Lenders usually regard borrowers as less risky when they have a guarantor – and therefore may charge lower interest rates or even approve mortgages they would have otherwise rejected.

However, if the borrower falls behind on their repayments, the lender might chase the guarantor for payment. In some circumstances, the lender might even seize and sell the guarantor’s property to recoup their money.