For many investors – how they pay for their deposits on investment properties is considered an afterthought, something which will not impact their long term finance or investing strategy. This can leave investors with less effective borrowing structures which can reduce their borrowing capacity and tax effectiveness.
The options for how to pay for deposits can generally be summarised into three main types:
As simple as the title – cash savings are used for the purchase deposit. In some cases this is the only way the deposit can be provide, for example if a new investor is buying their first property and they do not own any other property that they can draw equity from.
Provide equity (not releasing funds)
If you’ve made a purchase without providing any deposit funds, instead using the equity within a property without releasing the equity as a top-up or equity release, it’s likely you’ve cross collateralised. This means the new purchase loan is secured against two properties – a poor structure type which can cause long term financing issues, reducing flexibility and put your portfolio at unnecessary risk.
For the most part cross collateralisation is completely unnecessary as through simple structuring techniques you can still use your equity to make additional purchases, whilst still keeping each property separate from the other.
There are limited exceptions where cross collateralisation can be justified – such as family guarantees where parents provide additional security for their children to purchase a property. This can be an interim solution which with the right structuring and careful planning can have the guarantee released and cross collateralisation risk removed in the short to medium term.
Pay using borrowed equity
The preferable solution for all scenarios where the borrower has property – funds are released from an existing property as an equity release or top-up. These funds are then used for the deposit to purchase a property, and then remaining purchase funds borrowed against the new property. This allows the investor to effectively borrow 100% of the purchase price + government charges – maximising their deductible interest.
For a scenario where the borrower has cash and no available equity in an existing property (it may be fully leveraged), a debt recycling strategy can be setup, wherein the cash funds are used to pay down the existing (non-deductible) home loan, then a new equity release split is setup and funds released for the deposit. The net result is the same debt levels as paying cash and having a remaining high home loan, but instead there is a reduction in non-deductible interest and increase in tax deductible interest.
300k purchase, 15k government charges, 90% LVR
45k equity release loan is setup against property 1 (existing property), providing the 45k funds needed for deposit
270k loan attached to property 2 (new purchase, providing the remaining loan for the purchase)
Net result is 100% of purchase price and costs funded through lending
What is the best option for me?
This does come down to your personal situation – however as a general rule for deposit funds for an investment property borrowing for the deposit through a separate equity release will provide the most efficient use of funds, whereas if it is for a principal place of residence utilising cash funds is more suitable. Likewise if there is no existing properties in the investor’s portfolio where they can draw equity or pay down debt to recycle deposit funds, utilising cash may be the only option available.
To understand the tax implications and what is best for you, it’s best to seek specific advice from your accountant and financial adviser who can ensure your lending plans fit within your tax strategy.
If you would like to have a discussion about your lending structure and the options available to you, click here to connect with us today