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Case study - John Simpson
John has been a self-employed carpenter for 10 years, and operates his business under a company structure.
He has approached you for help in arranging finance for a potential purchase of an investment property. He was referred to you by his accountant, who is a friend of yours. Apart from purchasing the home he currently lives in some 12 years ago, he has had no other experience in dealing with a mortgage application, though he has recently obtained finance for a new work truck via his local bank.
He has found a property he likes, and has already secured the services of a solicitor to assist with the purchase.
John currently owes $375,000 and estimates his home to be worth $650,000.
He has agreed to purchase the investment property for $300,000 and needs to borrow the full purchase price plus $20,000 to cover stamp duty, and other associated costs including a $5,000 ‘cash reserve' in case there are delays in securing a tenant for the property.
After reading the case study above, answer the questions below.
Task - Using equity
1. How is it possible for John to borrow 100% of the purchase price + costs?
2. Assuming John uses the same bank to finance his home and the investment property he wishes to purchase, what is the loan to value ratio (LVR)? Please show the percentage up to two decimal places in your answer.
3. Explain how applying for a ‘Low Doc Loan' could lead the mortgage broker to be accused of recommending an ‘unsuitable' product.
4. Although some of these stages do not involve the mortgage broker, briefly explain why it is important to keep abreast of developments.
5. What are the Lender's legal obligations if they decline an application due to the content of the credit agency file
6. During the course of the loan process, John is starting to become upset with the time it's taking to get him an approval. Although you've explained that this is because of delays with the lenders processing system due to staff being away, you're concerned the matter may escalate beyond your control.
If COSL was your EDR provider, explain their role in the process.
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When talking about to borrow 100% of the purchase price + costs most savvy investors mean they are using 100%+ borrowed funds. I will suggest John, if he is not able to save up a deposit, or wish to avoid paying Lender's Mortgage Insurance (LMI), in that case a guarantor will be helpful. In any circumstances, if John cannot repay the loan, then the guarantor will repay the loan. This lowers your risk as a borrower and allow John’s bank to lend as much as 100% of the purchase price of a property. However it is not necessary that John willborrow all the funds using one security or using one lender. In many cases borrowers need to offer other security to make up the equity shortfall, which helps in avoiding LMI completely but John should keep in mind to maintain the maximum deducibility for his borrowings.
A great deal also depends on John’s investment strategy ie: positive gearing or negative gearing. Positive geared properties are typically high rental yield, low entry cost such as small regional towns or small inner city apartments or even student accommodation. These properties will offer John the investor strong returns however as the security they are less attractive to lenders. In this case, I can expect lenders to offer lower LVR and discount the rental returns on some of these securities. The result is that John may have a good cash flow however he may not be maximising his use of equity. Negative gearing is aimed at gaining tax and asset appreciation advantages and are typically in metropolitan bricks and mortar.