It might seem like a risky decision, however buying that second piece of real estate could be a good decision if you’re prepared to make the commitment.
So, before you take the plunge, here are a few things to consider.
1. Consider the cash flow
A second mortgage is going to have a significant impact on your monthly cash flow, so make sure you're in a position to service both of them by having a stable income. While affording two mortgages is great in itself, you don’t want to skim by. Ensure you have a comfortable buffer zone to prepare for any mishaps that may happen along the way.
From the lender's point of view, the key to minimising risk as a borrower lies in your ability to earn enough income to service your first and second mortgages successfully on top of the cost of living.
This not only ensures you're ready to take on a second mortgage, but it also satisfies your lender's requirements for approving the additional finances.
2. Why are you buying a second property?
What is driving you to buy a second property? Are you investing for the long or short term? Are you looking for a holiday home down by the seaside? Or are you looking to move into your dream home for your growing family?
Depending on your answer, this will help influence important decisions such as the type of property you’ll buy, the location, and how much you’re willing to spend.
If you're buying a second home for investment purposes, try to get your hands on a rental estimate letter from the real estate agent currently handling the property.
The lender requires this letter at the application stage and it's important to keep in mind that it's unlikely that your lender will take 100% of the rental income into account as part of your serviceability calculation. They generally factor in around 50–75%, depending on the property type and its location.
To ensure that loan serviceability doesn't become an issue, it's imperative you choose a property that's well located and continues to generate a constant income to support itself.
This means looking for places in areas that have high tenant appeal, good rental returns, and potential for capital growth. Also, ensure the location you choose has all the sough-after amenities nearby such as cafes, shops, public transport, good schools, hospital, etc.
When purchasing a holiday home, the first thing to ask yourself is how long you plan on staying at the property. Will it be a regular weekend gateway? Do you plan on renting it out in the peak season?
If you’re considering purchasing a holiday home that you will only use occasionally, it may be wise to view it as an investment opportunity. By renting out the property for extended periods, such as through Airbnb, you could potentially cover some or all of your mortgage payments with rental income. This approach could allow you to generate a return on your investment.
Don’t forget there are various costs associated with owning a rental property, including maintenance, insurance, and property management fees, which should be factored into your financial calculations.
Also remember to consider the tax arrangements.
According to the ATO:
If you own a holiday home and don't rent out the property, you don't include anything in your tax return until you sell it.
If your holiday home is rented out, you need to include the rental income you receive as income in your tax return.
You can claim expenses for the property based on the extent that they are incurred for the purpose of producing rental income.
3. Do you have equity in your first property?
Using equity in your first home could get you on the property ladder (once again) in no time.
Home equity represents the value of your property that is not tied up in your mortgage. Over time, you may accumulate equity in your home by making regular mortgage payments and benefiting from any increase in your home's value.
If you have built up enough equity, it may be possible to use it as collateral for the loan on your second home. This can be an alternative to providing a cash deposit and can potentially offer you more flexibility when financing your second home purchase.
However, it's important to carefully consider the risks and benefits of using your home equity to secure a loan, as it can put your first property at risk if you are unable to make your loan repayments.
Here is an example of how it works:
Sharon’s house is valued at $400,000 and her outstanding debt is $220,000. This means the equity in her home would be $180,000.
However, most lenders allow borrowers to access up to 80% of their property’s value minus the outstanding debt.
So, 80% of Sharon’s property value is $320,000. If you take away the outstanding debt of $220,000 from that number, Sharon is left with $100,000 of useable equity.
4. Have a safety buffer in place
If you are planning to use your existing owner-occupied property as security to fund the deposit for the second one, you are putting yourself at risk of losing both if you find you can't meet the repayments.
This is why it's essential to have a strong contingency plan. Depending on your ability to save, a safety buffer could come in the form of three to six months' worth of repayments and living expenses.
If you're planning on having a family, it’s important to have a comfortable financial back-up plan for when your dual income is temporarily whittled down to one wage.
"It's vital that those taking out a second home loan take family planning into account for the future, because this is how a lot of people get into trouble,” said Philip Minett, Owner and Principal of Mortgage Interchange.
“Not everyone plans to have another child but it happens, and this adds a lot of financial stress to the process.”
5. Reassess your borrowing capacity
Like any other home loan application, your second mortgage is assessed on your overall position in relation to your income versus expenses, and assets versus liabilities.
This means that if you have a mortgage or other credit already, such as personal loans and credit cards, your borrowing limit may be less less than if you were debt-free.
Your lender will factor in both your deposit and your possible rental income (if applicable) to determine your loan to value ratio (LVR).
If you’re taking out a second mortgage for another owner-occupied property, you may be able to borrow up to 100% LVR – if your lender agrees that you can service the debt. However, for investors, your lender may cap this LVR at 80% or 90% to reduce the risk involved, both to you and them.
"Investment properties are by nature bigger risks for lenders," Mr Minett said.
"The property isn't the roof over your head and, if you've got tenants in there and something goes wrong, borrowers are more likely to walk away from an investment property as opposed to their owner-occupied ones.
"If you've got a high income but low equity in the family home, your borrowing limit is reduced. You have to have that good combination of equity and income.”
Another thing to think about are rising interest rates. While you may be able to afford a 5.5% interest rate, could you afford your mortgage if rates rose to 6% or more?
When evaluating your loan application, lenders take into account your capacity to repay the loan with a higher interest rate. Typically, lenders will assess your ability to meet your loan repayments at an interest rate that is at least 3% higher than the loan product rate. For instance, if the loan product rate is 5.5%, the lender will check if you can repay your mortgage if rates increase to 8.5%.
While lenders perform this calculation, it's essential for you to also consider this aspect carefully from your end.
How can you maximise your borrowing capacity?
If your lender has approved your second home loan for less than you expected, and you want to stretch it out further, the first question you must ask yourself is whether you can actually afford it.
Your lender will have set your borrowing capacity at a safe limit that it feels prevents you defaulting if rates were to rise any higher.
If you’re determined to increase your borrowing capacity, there are steps you might like to consider.
First, make an effort to pay off your credit cards and cancel them, and also get rid of any other debts.
Then, to boost your chances further, think about applying to a different lender. Each lender has different assessment criteria and you may be able to stretch your approval. Keep in mind that applying to multiple lenders has a negative impact on your credit record as lenders can use your credit record to see how many times you make applications. This could then lead to your application being rejected.
If need be, you could seek help from an experienced mortgage broker who knows which lenders are likely to be more flexible with their borrowing capacities.
6. Decide on a loan type
When you take out an investment loan, you’ll choose between a fixed interest rate, variable interest rate, or a split loan.
Fixed rate - A fixed home loan is when the interest rate is locked in for a set period of time, typically between one and five years. A fixed rate option can be a great idea for second homebuyers who want the security of knowing exactly what their monthly repayments are going to be. However,
Variable rate - A variable home loan means the interest rate will move up or down during the loan term. This usually occurs at any time at the discretion of the lender, but most commonly occurs in line with changes to the official cash rate set by the RBA. Variable rates tend to be more flexible than fixed rates as they offer features such as redraw facility, offset account, or the ability to make extra repayments.
Split loan - This is where a portion of the rate is fixed and the other portion is variable. This could be a 50/50 split or an 80/20 split - whatever is agreed upon by you and the lender.
Once you’ve considered all of the above, and you’re confident you can afford a second property, it’s time to make your purchase!
Lenders consider many different factors when you apply for a second home loan (including equity, income and debt) so it’s important to be certain you can afford a second slice of real estate before diving in to the deep end.
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