What is Lenders Mortgage Insurance (LMI), and do I need it?
Many people are surprised to learn that banks take the equivalent of an insurance policy over your home loan. The purpose is to cover themselves financially in the unlikely-hood the home buyers default on mortgage repayments.
The bank usually absorbs the insurance cost in its fees, charges, and interest of the loan.
If your deposit is less than 20% of the purchase price, which means your loan to value ratio (LVR) for the purchase of your property exceeds 80%, – then banks and financial institutions consider this a higher risk. In these instances, the “premiums” for this “insurance” which protects the lenders also increases dramatically.
As the bank is unwilling to absorb the extra cost, they pass this “policy payment” to the borrower for payment. This insurance policy is known as “lenders mortgage insurance”, or “LMI”, and the fee is known as the LMI premium.
So yes. If you purchase a property with less than 20% deposit you will need Lenders Mortgage Insurance.
Is Lenders Mortgage Insurance a one off payment, and is it tax deductible?
Yes, the “LMI premium” for the lenders mortgage insurance is a one-off cost. LMI is usually paid upfront and not spread across the loan term. When purchasing an investment property, it is deemed a “borrowing cost” by the ATO, and as such, it is tax-deductible.
It is the borrowers choice whether the expense is written off over the first year, or across the term of the loan. The decision is usually dependant on the financial situation of the purchasers and taken in consultation with their financial planners, mortgage brokers, or accountants.
So, what is a "Lenders Mortgage Insurance" investment strategy, and how does it work?
The secret comes down to the current property market, and whether property values are increasing or decreasing.
Allowing for the tax-deductibility of the LMI fees and charges, property values need only rise by around 1.5% per annum for the payment of lenders mortgage insurance to be worthwhile.
Let us take a hypothetical purchase of a property, and revise the results that different purchasing strategies would show in a year;
- Mr and Mrs Jones have borrowing power and can meet the various loan terms.
- All purchasing costs, such as stamp duty and legal expenses, are put aside, and they have no reliance on any homeowner grants.
- They have a residual $50,000 which they would like to use as a home loan deposit for their $500,000 Investment property.
- $50,000 deposit on a $500,000 property gives an LVR, or loan to value ratio, of 90%.
Mr and Mrs Jones have three property purchasing strategies:
Purchase a $250,000 property using the $50,000 as a 20% deposit. By avoiding paying lenders mortgage insurance and purchasing an investment now, they can obtain an 80% home loan on a cheaper property.
Assuming a suburb growth of 2.75% pa, a year after settlement they are owners of an investment property now valued at $256,875 – a capital growth of $6,875
The purchasers can avoid paying LMI by saving an additional $50,000. They then pay the required 20% deposit of $100,000 to buy an investment property with a $500,000 purchase price.
It is a year later, and they have now saved their additional required deposit. Assuming the same suburb growth of 2.75% pa, the property valued at $500,000 that they are buying now, cost only $486,650 last year.
This results in an initial paper loss of $13,385. The loss, if then coupled with the $13,750 that would have been gained after a year of ownership equates to a potential capital loss of over $27,000.
Pay a low deposit of 10%, pay for LMI, and purchase the $500,000 investment property immediately.
Mr and Mrs Jones purchased in the same suburb with 2.75% per annum growth. As they had a home loan deposit of only 10%, they attracted a lenders mortgage insurance premium of $14,200, and government fees and charges of $1,500.
The investment property, purchased for $500,000 has increased in value to $513,750.
The additional cost for LMI and fees of aproximately $16,000, is tax-deductible, and the expense may be written off.
This results in a profit to the Purchasers of $13,750.
In this simple scenario, we did not take into account further variables such as the loan repayments, stamp duty, or any further applicable fees and charges; however, there are several points of note;
1. The extra expense of LMI was worth paying. It is an upfront cost, so must be budgeted for as the funds cannot be a loan, but it can be claimed as a tax deduction.
2. It is not the gain in the first year a “procrastinator” is missing out on; it is the substantial gains of the compounding growth in the final years that are lost.
and 3. –
So, how can Lenders Mortgage Insurance benefit you?
The majority of Banks and financial institutions have online calculators and tools that you can use for rough estimations on how this strategy could work for you. For example, access the Westpac lenders mortgage insurance calculator, stamp duty calculator, and home loan calculator here.
By using and becoming familiar with these tools, you can have a better understanding of how the different financial planning decisions you make now could make a difference for the future. We do not necessarily recommend you use the services of a bank for your financial questions.
We believe it is in your best interest that you use the independence of mortgage brokers, accountants or financial planners well versed in property investment.
Through our many years of work with investors we have compiled a list of financial professionals we can recommend.
If you have any questions before buying or investing in property, give the experts at TIPP a call on 1800 00 8477 to discuss any aspect of your investment journey.