When you’re buying a house or an investment property should you use a small or a big deposit? There are advantages and disadvantages to both so let’s have a look at these two options.
I’ll start with the advantages and disadvantages of saving a large deposit.
Avoid Lenders Mortgage Insurance (LMI)
Lenders Mortgage Insurance is a fee the banks will charge in order to cover the risk that they’re taking if your deposit is less than 20%. If you get a loan and the bank only has to lend you 80% then they can be more confident that they will get that money back if you default on the loan and they have to sell your property.
With a 5% deposit however banks are not confident that they could get their 95% back. There’s increased risk for them and that’s why they charge this insurance premium if you don’t have a large deposit.
Access to easier financing
Certain areas like country towns often require at least a 20% deposit because fewer lenders come into the area. But depending on your situation you may be able to find easier financing if you have at least a 20% deposit as opposed to a 5% or 10% deposit.
From previous research that I’ve done if you’re building a new property and need a construction loan then generally a 5% deposit isn’t going to be an option. If you want to get financing then you really need to have a deposit that’s at least around 10%.
Access to better deals or interest rates on your loan
If the banks are taking less risks then they might be willing to cut down the interest rate and do a better deal with you. But you really need to speak to your lender or a mortgage broker because lending changes all the time.
If you want to get in touch with my mortgage broker go to onproperty.com.au/mortgage and enter your name and phone number and he’ll give you a call.
Access equity faster without paying LMI
The following should not be considered financial advice.
Using a rough example let’s say that you’re buying a property worth $500,000.00 and you put down a 20% deposit (which is $100,000.00). You would now have a $400,000.00 loan on that property.
Effectively you have $100,000.00 in equity in the property which is remaining value. As the property increases in value your equity also goes up in value and your ‘loan-to-value ratio’ goes down. So when you have $100,000.00 of equity in the property and $400,000.00 of loan then that means you’ve got an 80% loan-to-value ratio. But if that property goes up in value to $700,000.00 then you now have $300,000.00 in equity versus $400,000.00 in loan on the property. As you can see the ratio is now very different.
What this means is that any extra equity you gain from an increase in value on your home brings your loan-to-value ratio below 80%. And with most lenders you can get an equity loan without paying LMI as long as you don’t go over the 80% loan-to-value ratio.
If you were to use a smaller deposit like 5% then as the value of your property goes up your loan-to-value ratio might eventually drop to 80%. But even if it dropped to 80% you would have to bump your ratio up to 90% or 95% in order to access another equity loan and then you would be charged LMI again.
So if you’re getting a 95% loan then it’s going to need to get lower than 80% (which means your property will have to continue going up in value) in order for you to be able to access equity without having to pay LMI again.
The topic is difficult to explain but I hope that it came across properly.
Larger deposits take longer to save
For a $500,000.00 house a 5% deposit is going to be $25,000.00 versus a 20% deposit which is $100,000.00. Depending on your financial situation you may be able to save $100,000. But for some people saving $25,000.00 versus $100,000.00 are drastically different.
By opting for a lower percentage you can save the money quicker whereas it will take you longer to save a larger deposit.
More time out of the market
If you’re spending time saving money in order to get a large enough deposit then that’s time that you’re not in the market. This means you won’t be taking advantage of market growth and capitalization of your property. So while there are advantages to a large deposit you’re also missing out on potential growth since properties tend to continually grow.
Now we will take a look at the advantages and disadvantages of a small deposit.
Access the property market faster.
You don’t need to save as much money in order to get it which means you don’t need to spend as much time saving up. Being in the market earlier means you have the potential to get growth sooner.
Growth could mean the natural tendency of the market going up over the years. Additionally you could also own a property and improve on it with renovations that will increase the value of that property and thereby manufacture growth.
You need to pay LMI
We discussed Lenders Mortgage Insurance earlier which can cost thousands of dollars. In some cases you can get LMI added to the loan so it doesn’t have to come out of your own pocket. However with it added to your loan your interest repayments are going to be slightly higher and its going to take you longer to pay it off.
Potential trouble with lending
This can depend on your financial situation and what your borrowing capacity is. There are many different factors that go into this but only having a 5% or 10% deposit may restrict what lenders you can go with and rule out lenders that would have seen you favorably if you had a 20% deposit.
So by having less you’re potentially ruling out some lenders which can make it harder to access financing. However visit your mortgage broker for more advice on this issue.
Higher interest rate with some lenders
Higher interest rates are another disadvantage but again you will want check with your mortgage broker.
Need more property growth to access equity
Like I discussed earlier having a larger deposit allows you to have access to equity as your property grows. However with a smaller deposit first you have to go below an 80% loan-to-value ratio before you can access any equity without paying Lenders Mortgage Insurance.
So there are some benefits and disadvantages to having a large or small deposit.
Your decision is going to be is up to you. I don’t know your situation or financial position so please don’t take any of this as financial advice. It is for educational purposes only. However I hope looking at the pros and cons have helped you get some clarity and help you to make your decision. I wish you good luck with your investment journey.
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Until tomorrow remember that your long term success is only achieved one day at a time.