By Rich Harvey, CEO & Founder, propertybuyer.com.au
The world of home ownership and property investment comes with its own language and ideas. It can be overwhelming for new entrants as they wade through the acronyms and terms. But it’s worth the effort because there’re concepts among the vernacular which can help you achieve the best possible outcome from real estate.
One which can be frustrating for buyers is Lenders Mortgage Insurance, or LMI as it’s known. Most try and avoid LMI like the plague, claiming it’s costly and delivers no benefit to the borrower… but I beg to differ.
In fact, if utilised correctly, LMI can help you get into the market sooner and start building more wealth over the long term.
Here’s how.
What is LMI?
LMI is an insurance policy that covers the lender against losses if the borrower defaults on their loan. The borrower is paying for the policy, but the beneficiary will be the lending institution.
The way LMI is applied to a loan depends on your loan-to-value ratio (LVR). LVR reflects the percentage of borrowed funds again the value of the property securing them. For example, if you buy a $1 million property and borrow $800,000 from the bank to pay for it, your LVR is 80 per cent.
Loans at or below 80 per cent don’t require LMI which is why many buyers try and save a 20 per cent deposit for their purchase. If you agree to include LMI as part of the loan, lenders may approve borrowing at an LVR of up to 95 per cent in many cases.
The cost of LMI varies based on the amount you’re borrowing and the level of LVR – the higher you’re LVR and property value, the more LMI premium you will pay.
To give an extreme idea of cost, if you bought a $700,000 property and borrowed 81 per cent of the funds, LMI would be about $3000. At the other end of the scale if you bought a $1 million property and borrowed 95 per cent, your LMI would be closer to $60,000.
The most accurate way to estimate your LMI premium before you buy is to use an online calculator. A simple Google search will reveal plenty of options.
Why you shouldn’t necessarily avoid LMI
LMI can feel like ‘wasted money’ on the surface, but there are several reasons why it can work in your favour as a borrower.
First, it’s important to understand the LMI premium is usually capitalised back into the loan, so you aren’t required to pay it as a lump sum at settlement. Instead, you’ll be paying it down with the home loan.
The second factor is that LMI buys you time in the market.
LMI lets you purchase with a smaller deposit, and that means you can take advantage of capital growth and rental returns sooner. This is particularly important during periods where property values are growing at a faster rate than your ability to save.
Let’s look at the Sydney market as an example.
If you were a first homebuyer and wanted to purchase a $700,000 at the start of 2021 with no LMI, you would require a $140,000 deposit (i.e., 20 per cent).
You could spend the year squirrelling away all your cash, living at your parent’s place and doing two jobs to amass the funds.
Let’s say you manage to get the money together by December 2021. Good job! Unfortunately, that $700,000 property is now worth $840,000 because the market rose around 20 per cent in that time. This means your LMI-free deposit now needs to be $168,000. After all that work, you’re still short $28,000!
Same scenario but this time you do a 95 per cent loan and draw on LMI to help you purchase as soon as possible. Although the LMI premium will be high at around $28,000, you only need to pull together a $35,000 deposit to buy (five per cent). You get into the market sooner and enjoy all the benefits of capital gains – $140,000 worth in this example –which will be a great launch pad for a future purchase.
Even if markets slow down, the average capital gain is still around seven to 10 per cent a year. It makes sense to get in sooner and take advantage rather than chase your tail trying to save a huge deposit.
And the premise works whether you’re a first homebuyer, upgrader, downgrader or investor. LMI is simply a tool to ensure you get maximum time in the market. I have used this strategy of paying the LMI to leverage my deposit safely – which enabled me to buy two investment properties instead of just one at the early stages of my property investing career.
Of course, it’s important to think about these matters in the context of your own individual financial position and borrowing requirements. For that, look to draw on the expertise of an experienced finance broker. The broker will work through your borrowing capacity and secure the best finance options and help you buy sooner. As professional buyers’ advocates, we work closely with top mortgage brokers to help you achieve your property goals faster.
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