Monday, May 23, 2011

Borrowing $400,000 from the bank

Whoa, I can borrow more than $400,000 

My bank ran some preliminary numbers and said that they can probably arrange a pre-approval for me to borrow $400,000. And that's on top of my current loan commitment. The average Australian loan is about $360,000. If I were to fully leverage myself, then my aggregate investment loan balance would vastly exceed the average loan.

Would you borrow that much?

If your bank offered you an additional loan of $400,000, would you accept their offer?

I'd be crazy to borrow the maximum amount and gear myself to that extent. It's a bad move to over-leverage and also a bad move to under-leverage.

Why is it bad to be under-leveraged? Currently, I'm under-leveraged which means that I have the potential to buy more investment assets and service a greater loan. This can potentially translate to greater passive income and capital gains but I'm not taking advantage of that because I'm under-leveraged. Next year I plan to buy another investment so that should sort out the under-leveraging situation. Although I wouldn't borrow the maximum because that could topple like a house of cards.

Why is over-leveraging risky? No-one should be borrowing up to their maximum servicing capacity(your ability to repay loans) because it doesn't leave any rooms for errors, disruption to the income stream (job loss or fluctuations in business revenue) and it'll probably be rather stressful when you're walking on a financial tight rope. If you subject yourself to high risks, then you're subjecting yourself to the risk of having to liquidate your investments (shares or property) at an inopportune time, therefore, realising your losses and not having the ability to ride out asset price fluctuations.

How do you work out repayments?

I use my favourite site for their advanced repayment calculator. Although I've compiled my own spreadsheet with inbuilt formulas so no longer use this site but I recommend this one. Why? They have a fantastic loan repayment calculator. It's accurate and doesn't do shabby rounding ups and downs that ultimately give users inaccurate numbers like some of the other online calculators that I've checked out.

A loan of $400,000 at 8% for a loan term of 30 years means repayments of:

$2935.06/month OR
$1354.06/fortnight OR

Of course, if you are buying an investment then you'll be earning investment income so that could contribute towards the repayment. If you're in Australia, then you also get a tax deduction for interest paid and a raft of other tax deductions associated with the maintenance of your investment. After all these deductions, the cost that's coming out of your own pocket is significantly less.

What if I want to instead, maximise my borrowings?

If I really wanted to borrow the maximum, then I would be refinancing my current investments down to a loan valuation ratio(LVR) of 20% so that I could borrow up to 80%.

By doing this, then for every $1 that I have, I can borrow $4. This is how I can fully gear myself and risk over-leveraging:
  • If I have $100k then I can borrow $400k for a $500k investment.
  • If I have $200k then I can borrow $800k for a $1 million investment.
  • If I have $300k then I can borrow $1.2 million for a $1.5 million investment
Generally, you can maximise your borrowings and fully gear yourself without paying lenders mortgage insurance (LMI) if you have at least 20% to deposit.

Further reading:

1. 15 Tips On Paying Off Your Mortgage Faster
2. Understanding Loans and Their Features
3. Paying off your mortgage faster - The scenarios

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