A common question amongst first time and established investors is should I use a big or small deposit when buying a property?
There are advantages and disadvantages of using a big or small deposit when buying a property, so let’s have a look at both.
The pros and cons of using a big deposit:
You can avoid paying Lenders Mortgage Insurance (LMI)
LMI is a fee the banks charge in order to cover the risk they’re taking if your deposit is less than 20%.
Depending on your lender’s requirements, LMI allows you to borrow up to 95% of the purchase price of your home.
The benefit of putting down a larger deposit, anything over 20%, is that you can avoid paying LMI all together.
If you don’t have a 20% deposit, or you don’t want to put down a 20% deposit, you can use this online LMI calculator to work out how much LMI you will need to pay.
You may get access to easier finance
Banks are more open to approving loans when a larger deposit is provided.
This is because banks feel this larger deposit reduces their risk.
You will find lenders provide more competitive and flexible loans to those with larger deposits.
You can access to more competitive interest rates
Lenders like all businesses are open to negotiation.
The lenders also like safe and easy deals, which mean if you have a larger deposit you have more room to negotiate a better deal.
I recently bought my fifth investment property using one of the four major lenders. Just before I signed the final documents I asked for reduction on their interest rate. The bank said no and told me this wasn’t possible so I walked out of the branch. Later that afternoon I called my mortgage broker and asked him to get me to try and get me a discount. 2 days later he called me back with a 0.15% discount in writing from the same bank.
This one question will save me $1260 in interest over the next two years.
How much could asking the right questions save you?
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You can access your equity faster with out paying LMI
Equity is a slightly complicated topic, which I will address in detail in a future article.
For now please look at this example from Ryan at OnProperty.
Let’s say you’re buying a property worth $500,000.00 and you put down a 20% deposit, or $100,000, which means you now have a $400,000 loan on that property.
In theory you now have access to $100,000 in equity in the property, while in reality the bank will only lend you up to 80% of the value of the equity in the property.
As your property increases in value your equity also goes up, which means that any extra equity you gain from an increase in the value on your property brings your loan-to-value ratio below 80%. The good news is that most lenders will let you access the equity in a loan without paying LMI as long as you stay below the 80% loan-to-value ratio.
You will lose time in the market
One of the most common mistakes I see investors make is to try and save a 20% deposit before they buy their first or next property. These investors try and reduce their LMI with out considering the financial implication of time in the market.
Ben buys a $400,000 home in 2014. He saves a 20% deposit or $80,000 to avoid paying $12,578 in LMI. His home is currently worth $400,000.
Luke buys a $400,000 home in 2013. He decided to save a 5% deposit or $20,000 and pay the $12,578 in LMI. During 2013 his house increased in value by 7% or $28,000. His house is now worth $428,000.
While Luke had to pay the additional $12,578 in LMI, he is still $15,422 ahead of Ben due to this extra time in the market.
If you are buying and holding and know how to buy well a 5% deposit can be a great way to purchase property.
If you’re looking to make a short term profit I would consider coming up with a larger deposit to reduce your entry costs and increase the profit in the deal.
It takes time and energy to save a deposit
Similar to the scenario above the major downfall in saving a larger deposit is time out of the market. When saving a deposit you will not only need to make sacrifices in your lifestyle, you are working for your money as opposed to having your money work for you.
The pros and cons of using a smaller deposit:
You may be able to get into the property market faster
There are many arguments about investors timing the market or spending time in the market.
While both of these positions have held up in the past you want to put yourself in a position to jump when you find the right opportunity.
Please also see time in the market above.
You can use LMI to create leverage
LMI is a fantastic tool for cash poor investors to get into the property market faster.
As you become more familiar with LMI you will find there are often thresholds where you can find an acceptable balance between your deposit and LMI fee.
You will need to pay LMI
Unfortunately there is no escaping LMI if you are looking for a loan above 80% in Australia.
You may have to pay a higher interest rate
It’s no secret that lenders charge a premium for home loans with a higher loan to value ratio (anything above 80%).
Whether they do this to reduce their risk or because they can, you will generally pay a premium of between 0.25% and 1% for a loan with a higher loan to value ratio.
I recently built a $450,000 investment property using a 5% deposit.
I was able to secure a fixed loan of 4.89% on the land and a variable loan of 5.1% on the house. Had I used a larger deposit of between 10% and 20% I would have been able to select a more competitive rate from a wider range of lenders.
You may have potential issues with lending
Lenders are consistently changing their lending criteria based on a wide variety of factors in the global, national and local economy.
This means that during some stages of the economic cycle lenders will give out large numbers of loans with higher loan to value ratios, while in other stages they will tighten right up.
One day the banks may come knocking
In markets ,like 2011, there were many investors with high loan to value ratios.
Unfortunately some of these investors had recently bought over priced properties, at the top of the market, with a 95% deposit. This meant that when the values of their properties dropped by 10% they were over exposed.
This left many people in a position where the the banks came knocking to get more money and in many cases repossess the property.
This is by far the worst-case scenario when using a small deposit and the reason why you need to do your research and buy well.
Each investor will have a different perspective on whether they should use a big or small deposit when buying a property.
I personally have no problems paying lenders mortgage insurance, as long as I’m buying well and planning to hold the property over the longer term.
At the end of the day you need to decide for yourself what level of risk you are prepared to take and what level of LMI you are prepared to pay.