Types of Investment Loans

Residential Security

Typically, most investors who borrow utilise residential property as security – either their home, the property being purchased or a combination of both.

Generally the major risk to the borrower arises if the borrower fails to meet contractual repayments. This can cause the lender to foreclose on the property and sell it to repay the outstanding loan. The sale process is conducted by the lender whose primary aim is to recover their principal. This process may not necessarily see the lender maximising the value of the sale. The owner therefore will not receive the maximum potential value if the sale is not at full market value.

If a loan is secured over 2 properties you cannot be assured that the lender will sell the investment property only to recover their funds. They are quite within their rights to sell the family home to recover.

Margin Loans

Margin loans are typically used to purchase listed investments such as shares or listed property trusts. They are also used to purchase managed funds.

The major risk with managed funds comes due to the market movement of your investments. Unlike direct property investments, listed securities and managed funds are regularly valued, usually daily and as such can cause a margin call.

A margin call is when the market worth of your security falls. The result is the loan-to-valuation ratio (LVR) exceeds the allowable limits set by the lender. In this situation you will usually have three options:

  • deposit additional securities that you have
  • pay back part of your loan, and/or
  • sell your portfolio and draw on the profits to pay back part of the loan.

Your gearing loan provider will generally need the LVR to be returned to the arranged limits within a stated time period, usually within 24 hours. Although, when you borrow less than the maximum loan limit, you can decrease the risk of margin calls.

Some margin lenders have no margin call products where you might pay an additional interest fee for example. Some also have a repayment facility whereby instead of having to pay large lump sums off the loan in order to restore your margin loans LVR they will allow you to pay it off over a period of time. The good thing about this option is that if your investment value rises in the repayment period and takes you out of the margin call then the repayment requirements also cease.

Repayment Requirements

There are 3 types of repayment methods:

  1. Principal and Interest: We all know this method as it is typically the way loans are paid off for eg housing loans, personal loans, hire purchase agreements etc. Payments are designed to extinguish the debt over a set period of time.
  2. Interest Only: This method sees only interest payments being made (usually monthly). The principal remains constant ie it is not reduced. This is typically used for investment loan purposes
  3. Capitalised: No payments are made to the loan either interest or principal. This is usually a short term method whereby the lender may provide you with a facility for eg. $200,000 from which you only draw $100,000 to invest. The interest simply capitalises to the loan and can do so until the facility reaches its limit at which time interest only payments need to be made. This type of facility in particular can be useful particularly where the borrower may already have private debt such as a home loan but requires proper guidance in its use.

Types of Interest

There are 2 types of interest rates – Fixed and Variable:

  1. Borrowers can fix their interest rates on their loans for varying lengths of time (usually up to 5 years in Australia). Borrowers do this to provide certainty in their repayments and naturally it is best done when rates are at their lowest. In most cases lenders will not allow additional repayments to fixed rate loans.
  2. Variable rates are just that variable and will move up and down with the interest rate cycle. Additional repayments can generally be made to variable rate loans allowing the borrower to repay the loan in a shorter period of time.

Gearing may not be suitable for all investors. Whilst it can lower your tax liability, the tax implications will depend on your personal situation as well as your attitude to risk and the type of investment chosen. You should always seek qualified financial advice.

This information is of general nature only and is not intended as a personal advice. It does not take into account your particular investment objectives, financial situation and needs. Before making a financial decision you should assess whether the advice is appropriate to your individual investment objectives, financial situation and particular needs. We recommend you consult a professional financial adviser who will assist you.