Investing in a better rates deal

With interest rates falling, now is a good time to check your mortgage rate against those being offered by other lenders.

PORTFOLIO POINT: Rather than setting and forgetting, property investors should be proactive and review their finance arrangements on a regular basis.

In this time of falling interest rates, are property investors seeking and receiving the best deal from lenders in order to optimise their borrowing structure and minimise costs?

For many, the answer is probably not. It’s not just a case of entirely blaming the banks – investors also need to take responsibility for helping themselves and, in particular, what they should be asking existing or prospective lenders.

Each month, mortgage broking group AFG publishes its competition index. It tracks the proportion of borrowers who use a major lender – one of the big four banks or their subsidiaries – and the proportion who don’t.

As of April 2012, 29% of first home buyers and 24% of those refinancing a current loan were using a non-major lender as a source of finance, but only 17% of investors opted for a non-major. Moreover, while the non-major lenders’ share of the home buyer and refinancer lending markets has grown by several percentage points over the last 12 months, the corresponding figures for investors have remained steady over that timeframe.

Mark Hewitt, general manager of sales and operations at AFG, puts the broader improvement in small lenders’ market share down to two factors: on the supply side, a post-GFC improvement in these institutions’ access to credit markets and, from a demand perspective, the growing appetite of borrowers to seek a wider variety of choices. “Small lenders are really only now coming out of their GFC-induced fall in lending rates. At the same time, first home buyers are very willing to look outside the majors for their mortgage needs. This is good news for competition going forward.”

So why aren’t property investors responding in a similar way? Belinda Williamson, acting head of corporate affairs at Mortgage Choice, says that a lack of competition for investors’ business isn’t the problem. “The pool of lenders is pretty much the same for investors as it is for home owners. Investors tend to look for the same type of properties as first home buyers, and lenders offer them a similar and wide choice of products.”

Financial inertia

So, what exactly is the problem? Hewitt believes investors have been less proactive in responding to the signal of cheaper finance elsewhere. “When faced with the opportunity of shaving 20 or 30 interest rate basis points off their loan by going elsewhere, investors appear less willing to act than other borrowers, even though there are definitely plenty of choices for investors to move away from major banks to the non-majors.”

The relative inertia of investors may not be entirely about indifference. Many investors use the same lender for their home and their investment property borrowings, often using the equity in the home to help buy their first investment property. The familiarity of the existing relationship is a drawcard. “On average, investors are usually a little older than home buyers and perhaps more loyal to their traditional 'family’ lender,” says Hewitt.

He also points out that some major banks see investors as their natural client base and are very careful to look after these customers in order to retain their business and overall market share. “If they need to, major banks will offer much better terms than the headline interest rate to these favoured customers.”

Further, as many investors take advantage of negative gearing provisions, whereby they can claim a large proportion of their interest bill from the ATO, they are often less price sensitive to interest rate changes than home buyers, so are not as motivated to change lender if their current rate is marginally less competitive.

Nevertheless, with the current standard variable rate sitting at around 7%, while some lenders are offering investors a shade under 6%, there is plenty of scope for investors to save several hundred dollars a year in interest payments if they know what questions to ask and how to use industry competition to their advantage. You may not even have to change lenders to benefit.

Traditionally, the major banks provided some favoured customers 'professional package’ mortgages, which had a significant interest rate discount applied to them – sometimes as much as 1% – compared to the standard variable rate. The recipients tended to be high net worth individuals with sizeable loans. Over time, the criteria has softened, to the extent that a borrower with a reasonably sized loan – say $300,000 and upwards – and above-average family income is likely to qualify if they ask for it.

With interest rates close to generational lows and many fixed rates significantly below the long-term variable rate of 7%, now may also be time to ask lenders about the merits of switching from a variable to fixed-rate loan. Having said this, with some economists (most notably Bill Evans of Westpac) predicting rates to fall by another 75 basis points in coming months, after the RBA cut the cash rate by 25 basis points to 3.5% on Tuesday afternoon, the case for fixing now versus staying on a variable rate is finely balanced. Sometimes fixing part of the loan and remaining variable on the rest helps keep your options open.

Those who are thinking of changing lender should explore any exit fees their current lender might charge. Although exit fees have been banned since July 1, 2011 on any new loans, they still apply to many older loans, and can amount to several thousand dollars if triggered. Note that the level of the exit fee liability tends to diminish the longer a loan is held, and is usually vanquished once the loan is held for four or five years, depending on the wording of the loan contract.

What's the objective?

Obtaining a low interest rate shouldn’t be the only criteria for an investor’s choice of lender and product loan. The level of fees and charges can differ substantially between products, and can total several hundred dollars a year for some products. To improve transparency, lenders are required to provide an indicative 'comparison interest rate’, which factors in all these fees and charges.

Investors may also want the benefits of offset accounts and redraw facilities, as well as the choice of interest-only or principal and interest repayment loans. While it is common practice for investors who are negatively geared to opt for interest-only loans in order to maximise their buying power and annual tax return, some investors prefer to repay some principal as well, so they can pay down the debt.

There is a lot of merit in this latter approach from a peace-of-mind perspective. Once you’ve paid off the loan on a property, you are far more protected from the vagaries of economic fluctuations. At a minimum, I recommend all borrowers look for loans that allow the option of making additional principal payments without penalties, even on a fixed-rate loan.

Beware that your choice of investment property can inhibit your ability to source finance. It is definitely harder to obtain finance for a property smaller than 40m2. “This minimum size often excludes balconies, car parking and storage space,” says Williamson. “This restriction is usually at the behest of the lender’s mortgage insurer, who is concerned about the future saleability of the property.”

Furthermore, the form of title can be a factor when it comes to financing an apartment. Lenders prefer strata or stratum title, and tend to be much more conservative about lending against properties subject to company title – they often limit the amount they are willing to lend against the property to 65-80% of the value.

These financing issues illustrate that property investment is an active vocation – it can’t be just set and forget. It is therefore a good discipline to review your financing once a year, ideally with the assistance of an accountant or an independent mortgage broker. The objective isn’t to change lender every year. Indeed, it is likely that in most years you will decide not to change anything. But once in a while this annual borrowing health check is likely to uncover changes to your economic circumstances, significant savings and enhanced product features that should therefore be taken advantage of.

Property Q&A

This week:

  • Should my son sell his apartment or rent it out as an investment?
  • Will less tax relief in super equal a boost for property?
  • Building a granny flat.
  • Flood risks in Elwood.

Scaling up

My wife and I (we are in our mid-50s) are helping my son and his wife (they are in their early 30s) to buy a bigger home. My son’s family currently lives in a two-bedroom unit in Manly Vale, NSW which they bought in 2007. I’m considering giving them $200,000 to buy a three-bedroom home in Sydney in their own name. Should they sell the current apartment or rent it out as an investment property?

This gift is very generous. Let’s consider what might be the best way forward. It is likely that your son and his wife will need that gift, the receipts from the sale of the Manly Vale apartment and then a bank loan to buy a three-bedroom property in an inner-to-middle suburb of Sydney.

In relation to whether the Manly Vale property is worth retaining, there are a number of factors to consider. At around 12 kilometres out, the suburb is reasonably located. However, the suburb’s track record of growth – around 5% per annum over the last 10 years, according to Australian Property Monitors – is underwhelming and puzzling, especially given its proximity to the CBD.

Not having seen this property myself – and given that individual properties can perform differently to the wider or local market – I’d suggest you obtain an independent assessment of its capital growth over the last seven-to-10 years and future investment performance potential. Depending on the outcome of the assessment, you should base the decision to keep/not keep it on those rational results. If the results are unfavourable and you are still looking to invest in property, choose a one or two-bedroom apartment in a suburb within two-to-15 kilometres of the CBD that has all the right attributes: good transport links and proximity to amenities; and a unit that has a superior position and outlook in a small block of apartments with classic architecture and dedicated off-street parking on a quiet street.

Super boost

Do you think the tightening of tax relief on voluntary super contributions for those earning over $300,000 will see more people invest in property?

I’m disappointed that the federal government has reduced the super tax relief for high earners from July 1. Those earning over $300,000 will have to pay 30% tax on their contributions, rather than the current 15%. It’s a short-sighted step, but not for the reasons you might think.

If the government wants to avoid people being a burden on the state as they age, they should not discourage anyone from making the maximum possible provision for their retirement, regardless of their incomes today. But more pointedly, I believe this is the thin edge of the wedge. The reduction in tax relief will likely be extended to middle and lower income earners in time. Governments often test a policy on high income earners to gauge their tolerance before making it more widespread.

It is possible that some high income earners will divert funds into direct property outside of super in order to gain negative gearing tax relief at their top marginal rate of 45% (rather than at 30% in super) and to benefit from an effective capital gains tax rate of 22.5% (given the 50% capital gains discount for assets held for a year or more) when they eventually dispose of the property.

Realistically, I doubt there will be much of an impact on the property market. According to Treasury figures, there are only around 130,000 Australians earning $300,000-plus annually, and practically only a small number of these will pursue this strategy in any one year. For now, however, it’s a case of 'watch and wait.’

Granny flat

I’m considering adding a granny flat to my investment property to increase the value of the property and rental income. It seems to be all the rage. Is it a good idea?

In many instances, adding a granny flat will not be a route to increasing the value of the entire holding. A second and lesser property will almost certainly compromise the attractiveness of the primary dwelling and therefore its value. Sometimes this fall may be in excess of the lift received from the new property.

Living in a property with a granny flat close by is not everyone’s cup of tea, and only a small pool of potential tenants wants to live in a granny flat. So, you could be increasing the likelihood of prolonged vacancies in one or both of your properties. While the addition of the granny flat will increase the total rental income of the property, some of the additional rent gained by the second dwelling is likely to be offset by the rent falling for the primary property.

This is definitely not an approach one should take for a high-quality, capital-growth property – you’ll destroy your overall returns. It might have some merit if you have a high-yield property in an area where land values are low. But if you have access to cash or equity for investment purposes, it is better to diversify your holdings and buy a good quality one-bedroom flat in an inner urban area.

Note that adding a small 'flat out the back’ is not the same as a bona-fide dual occupancy project, where both dwellings are of a very similar size and standard of accommodation. These can work very well, as long as the site is well suited to such a project.

Elwood

I’m considering investing in Elwood, Victoria but a local council website map shows part of it is at risk from a one-in-100 year flood. Should I rule out buying in those areas?

Not necessarily. Nearly all of Melbourne’s bayside suburbs are at some (albeit minor) risk of flooding. Elwood’s risk is a little greater due to a canal running through it. Buying directly adjoining the canal is not recommended, although near the beach is okay. Note that there are low-lying parts of Elwood that have subsidence. For peace of mind, it is wise to commission a building inspection, and you will obviously markedly reduce the risk if you buy a first-floor flat or higher.

Monique Sasson Wakelin is a director of Wakelin Property Advisory, an independent firm specialising in acquiring residential property for investors. Monique can be found on Twitter: @WakelinProperty.

Note: We make every attempt to provide answers to readers’ questions, however, answers are of a general nature only. Subscribers should seek independent professional advice for more in-depth information that is specific to their situation.

Do you have a question for Monique? Send an email to monique@eurekareport.com.au

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