Updated: Ensuring your loans are structured correctly

By April 16, 2018Mortgages

loan structure

Your loan structure can have a big impact on your success as an investor. It can influence interest rates, borrowing capacity, cash flow, taxation liabilities and so on. Four years ago I wrote this blog which included 7 loan structuring tips and I wanted to update you on a few matters.

Funding a property owned in one spouses name only

It is common for a spouse that earns a high income to borrow to invest in a property to build wealth and reduce tax. However, this can cause some loan structuring problems these days. The best way to explain this is to use an example.

Case study

Ian and Karen are married. Ian earns $300k p.a. and Karen earns $50k p.a. Ian wants to own the investment property 100% in his name (as he’ll enjoy better tax savings). However, it might not be as simple as Ian applying for a loan solely in his name. He might have other existing debts which eat into his borrowing capacity and/or need to use some equity in jointly held property (such as the family home) to secure this new loan. Therefore, the bank might want Karen to also be party to the loan (so they can use her income or equity). This can cause two challenges:

  1. If we need Karen’s income: Often a bank will not accept a servicing (income) guarantee from a non-owner. That is, they will not include Karen’s income in the loan assessment unless Karen will own a portion of the asset being purchased (to prove that Karen has an economic interest in the loan). This is the case irrespective of the fact that Karen and Ian are married (or de facto).
  2. If we need Karen’s equity: If Ian wants to offer the bank additional security so that he is able to borrow all acquisition costs and if that security is held in joint names (e.g. family home), the bank will want Karen to be party to the loan (i.e. in the capacity as a either a borrower or guarantor).

Solution to item # 1

If the bank needs to rely on Karen’s income in order to approve the loan, then Karen will need to be on the title of the property (so Karen has an economic interest in being party to the loan). It might be acceptable for Karen to hold a nominal interest – say 1% – in which case Ian and Karen can purchase the property tenants-in-common with Ian owning 99% and Karen the remaining 1%.

An alternate solution to this is to secure the new loan solely using a joint property such as a home. In this case, Ian and Karen would jointly borrow sufficient monies solely secured by their home – see further comments under the heading below: “loans in joint names typically are not a problem”.

Solution to issue # 2

The simple solution here is to fund the property acquisition using two separate loans. The first loan will be for an amount that will cover 20% of the purchase price plus costs. This loan will be in joint names and be secured by the jointly owned property (home). The second loan will be for the remaining 80% and this loan can be in Ian’s name (as sole borrower).

Loans in joint names typically are not a problem

Having a mortgage in a join names doesn’t necessarily adversely affect the ability for one person to claim 100% of the interest deduction (i.e. the owner of the asset). This is the view espoused by the ATO in tax rulings (TR 93/32) and various private rulings (PBRs 1011362315461, 1011605760439 and 1011605989663).  Therefore, having a joint loan should not create any adverse tax impact. There is one thing you can do to strengthen your position and that is to ensure that repayments come from an account that’s solely in the owner’s name. Using the example above, Karen and Ian have a joint loan for a property owned 100% by Ian. The interest repayments for this loan should come from a bank account that is solely in Ian’s name (this account should also receive the rental income). In this case, we can prove to the ATO that Ian has funded 100% of the interest cost for a loan that was used to purchase an asset that is solely in his name only. Therefore, Ian should be entitled to 100% of the tax deduction.

Cross securitisation and maximising your borrowing capacity

Tip # 5 in this blog explains what cross-securitization is and why it’s not advisable (and this magazine article I wrote back in 2005 explains how to structure loans to avoid cross-securitisation).

I believe that avoiding cross-securitisation in today’s tightening credit environment is even more important. Borrowing capacities have reduced so much over the past couple of years that more investors are being adversely impacted. Therefore, it is important to retain the flexibility to use multiple lenders to extend your borrowing capacity and allow you to continue to build your property portfolio.

It is very important that you always borrow within safe limits and ensure you have enough buffers in place to accommodate changes in circumstances and higher interest rates. Our focus is to help our clients implement their investment plans and sometimes this requires careful planning i.e. using various lenders in a deliberate order.

Interest only versus principal and interest

In the past, I have always recommended establishing loan repayments as interest only as it gives you the flexibility to pay interest only or make regular/irregular principal repayments. Until recently, there hasn’t been any interest rate penalty for opting for an interest only loan. However, more lenders now charge a higher rate for interest only loans. The average margin is circa 0.50% p.a.

Whether its still appropriate for you to set your loans up as interest only will depend on your circumstances and financial goals. If you do not plan on making anymore investments and your cash flow permits (even after measuring the impact at higher interest rates), then switching to principal and interest repayments might be advantageous.

There is an alternative structure that you may like to consider that will provide you with the lower interest rate (that applies to principal and interest loans) whilst still maintaining the lower cash flow impact of interest only repayments. We would need to consider whether this is appropriate on a case-by-case basis.

Professional credit advice

As this blog highlights, loan structuring can be quite technical and have far-reaching consequences impacting things like taxation, cash flow, risk and your ability to implement your investment plans. Therefore, it is very important that you seek professional credit advice from a suitable experienced, qualified and licenced advisor. Of course, we stand ready and willing to assist you.