How To Finance an Investment Property
Investing in property can be an exciting way to build wealth, but figuring out how to finance that investment can feel daunting.
Don't worry, we've got you covered! In our latest blog, we break down the different options for funding your next real estate venture, from using your hard-earned cash savings to leveraging the equity in your current home.
We'll also dive into the nitty-gritty details of investment property loans, like interest-only vs. principal and interest, so you can make an informed decision that aligns with your financial goals. And of course, we'll cover some key considerations to keep in mind throughout the process.
So, buckle up and get ready to take the first step towards becoming a savvy property investor!
Taking Stock of Your Financial Situation Before Buying an Investment Property
Understanding Your Income and Expenses
Before diving into an investment property purchase, it's crucial to take a hard look at your current financial standing. Carefully assess your monthly income from all sources - employment, investments, side hustles, etc. Then tally up your regular expenses like housing, utilities, loan payments, groceries, and discretionary spending. Having a realistic picture of your cash flow will help determine how much you can reasonably allocate towards an investment property.
Evaluating Existing Debts and Credit Score
Your ability to secure favourable financing terms hinges largely on your credit profile. Lenders will scrutinise your credit score and existing debt levels when reviewing your application. A high debt-to-income ratio or low credit score could mean higher interest rates or even denial. If possible, pay down credit card balances and other loans to improve your credit utilisation. Checking your credit reports for errors is also a wise move before applying.
Assessing Borrowing Power and Down Payment
With a clear view of income, expenses, and credit standing, you can begin estimating your borrowing power for an investment property loan. Most lenders will require at least a 20% down payment to avoid private mortgage insurance. However, some government-backed programs allow lower down payments for qualified buyers. Online calculators can help model different down payment and loan scenarios. Just be sure to factor in costs beyond the mortgage like insurance, taxes, and maintenance.
Using Cash Savings as a Deposit to Finance an Investment Property
The Low-Risk Option
Using your cash savings to cover the deposit for an investment property is often considered the lowest risk option. By putting down a larger deposit upfront, you'll be borrowing less from the lender. This reduces your ongoing mortgage repayments, and the total interest paid over the life of the loan.
Avoid Lenders Mortgage Insurance
Another key benefit is avoiding lenders mortgage insurance (LMI). Typically, lenders require you to pay for LMI if your deposit is less than 20% of the property's value. Having at least a 20% deposit saved up allows you to sidestep this expensive one-off cost.
Potential Downside
The main downside of using your savings is that it may take longer to accumulate the necessary funds for a sizable deposit. This could delay your property investment plans. However, the reduced debt burden makes this a lower risk approach in the long run.
If building up your cash reserves is the preferred path, check out our guide on "10 Winning Tips to Help You Save for a House Deposit" for smart strategies to grow your savings faster.
Tapping into Your Home Equity to Finance an Investment Property
What is Home Equity?
Home equity refers to the portion of your home's value that you truly own. It's the difference between your home's current market value and the outstanding balance on your mortgage loan. The more mortgage payments you make over time, the more equity you build up.
Using Home Equity as Leverage
If you've built up a decent amount of equity in your primary residence, you can tap into that to finance an investment property purchase. This allows you to buy an income-generating asset without having to come up with a huge upfront cash deposit. The equity essentially acts as your down payment or deposit for the investment property loan.
How it Works
Your lender will calculate how much home equity you have available based on your home's appraised value and your remaining mortgage balance. They'll then let you borrow against that equity, up to a certain percentage, through options like a home equity loan or line of credit.
You can then use those funds towards the down payment and closing costs for your investment property. The property itself will serve as collateral for the new loan.
Potential Pros and Cons
The upside is not having to drain your liquid cash reserves, but the downside is putting both properties at potential risk if you can't keep up with payments. It's a leveraged investment strategy that can amplify your gains but also your potential losses.
You'll want to carefully assess your financial situation, risk tolerance and repayment abilities before going this route. As always, consult a qualified financial advisor to ensure it aligns with your investment goals.
Types of Loans Available for Financing Investment Properties
Principal & Interest Loans
The most common type of investment property loan is a principal and interest loan. With this option, your monthly repayments cover both the principal amount borrowed and the interest charged on the outstanding balance. As you make payments over time, the amount going towards the principal gradually increases while the interest portion decreases.
Interest-Only Loans
An interest-only loan allows you to pay just the interest charges for an initial period, usually between 1-10 years. This can help ease your cash flow burden in the short term. However, you'll eventually need to start making principal repayments, resulting in higher costs overall.
Lines of Credit
A line of credit acts like a revolving loan facility secured against your property. You can draw funds as needed up to the approved limit. Interest is only charged on the amount you use. This flexible option suits investors planning renovations or flipping properties.
Low-Doc Loans
If your income is difficult to document through traditional means, a low-doc loan may be an option. You'll generally pay a higher interest rate in exchange for less stringent income verification requirements. Be aware that lending criteria has tightened in recent years.
No matter which type of loan you choose, always compare options from multiple lenders. An experienced mortgage broker can provide invaluable guidance and support through the process.
Important Considerations When Getting an Investment Property Loan
Loan-to-Value Ratio (LVR)
The loan-to-value ratio is a key factor lenders consider when approving an investment property loan. It represents the percentage of the property's value that you'll need to borrow. Most lenders cap investment loans at an 80% LVR, meaning you'll need at least a 20% deposit. The lower your LVR, the less risk for the lender - and potentially better interest rates for you.
Rental Income
Lenders want to see that your investment property will generate enough rental income to service the loan. As a rule, the expected rental return should equal or exceed the proposed loan repayments. Providing evidence of strong rental demand in the area can strengthen your application.
Tax Implications
Investment properties have different tax implications compared to an owner-occupied home. You may be eligible for deductions on expenses like interest, repairs and depreciation. However, you'll also need to pay tax on any rental income earned. Consulting an accountant or financial advisor is wise before purchasing.
Loan Features
When comparing loans, look beyond just the interest rate. Fees, offset account facilities and flexible repayment options can all impact your cash flow. An interest-only loan may suit if you're primarily seeking to grow the asset value. But principal & interest loans allow you to build equity over time.
Professional Advice
Property investment is a major financial commitment. It's crucial to seek professional legal and financial advice tailored to your circumstances. A mortgage broker can guide you through the entire process - from assessing your borrowing power to negotiating with lenders.
Find your next investment
So, there you have it - the lowdown on financing your investment property dreams. While there are a few options to weigh up, don't get bogged down in the details. The key is understanding your financial position and borrowing power.
With some savvy planning and the right loan, you can make those property profits a reality. Just don't go diving in without doing your homework first.
Speak to the experts, crunch the numbers, and make sure you're clued up on the tax implications. Then get out there and start hunting for your next big investment opportunity - your future property mogul self will thank you
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