Loan Tip: Using Cash as Security for a loan
It is best not to use cash as deposit for an investment property, especially if you will have a main residence loan. Using cash on an investment reduces your deductions and increases your non-deductible interest.
But what do you do if you don’t have a main residence at the moment, but at looking to acquire one soon?
It is possible to use cash as security for a loan. Normally you may not want to or need to do this, but it is possible, and it can assist with maintaining high interest deductions in some situations.
Generally, the security used for a loan does not affect the deductibility of interest. This means anything can be used as security for a loan without effecting the deductibility of interest. The security could be shares, cash or even a car.
The beauty of cash is that it doesn’t need to be valued or sold for the lender to recover its money so the potential LVR on a loan secured by cash is 100%.
Tom has $100,000 cash and wants to buy an investment property for $500,000 before he buys his Main Residence. He might be doing this because he has found a ‘bargain’.
Normally Tom would pay a $100,000 deposit and then borrow $400,000 for the $500,000 property. But doing this would mean that going forward Tom would have $100,000 less for the future main residence. He may be able to access it and borrow against the investment property, but this will have some bad tax consequences:
$100,000 x 5% = $5,000 less per year in tax deductions for the next x years (life of the loan).
So instead using the cash as a deposit Tom could use the $100,000 cash as security and borrow $500,000. Ideally this would be done in the form of 2 loans
Loan A $400,000 secured by a $500,000 property. LVR 80%
Loan B $100,000 secured by a $100,000 term deposit. LVR 100%.
Tom could wait for capital growth (from natural market increase and/or a quick reno) and then release the cash, or if Tom quickly buys the new main residence the cash could be released, and the main residence used as security for the investment loan.
This could happen like this:
Loan A $400,000 secured by the IP. interest deductible against the IP
Loan B $100,000 now secured by the main residence. Interest is deductible against theIP
Loan C $400,000 secured by the main residence. Interest not deductible. The $100,000 term deposit is released and used at settlement to pay for $100,000 of the purchase price of the main residence.
Overall 90% LVR.
As above. $500,000 property with a $500,000 loan secured by both the property and the cash.
After 2 years the property is now worth $625,000. Tom applies to remove the cash as security and the bank agrees as the LVR is now 80% based on the property value alone.
$100,000 cash is then used as deposit for the main residence. Tom has an extra $5,000 per year in tax deductions for the next 30 years plus.
Tom has 2 properties securing 2 loans at ABC Bank.
Tom sells his main residence and will buy a replacement main residence in a few months. The trouble is Tom didn’t realise that his investment property was also secured by the main residence. The investment property is relatively new and hasn’t grown in value so the bank is insisting that $100,000 of the proceeds of the sale of the main residence be used to reduce the loan on the investment property.
Tom refuses and the bank refuses to discharge the mortgage on his main residence so his sale cannot settle.
Luckily there is a solution. Tom lets the bank keep $100,000 from the sale in a term deposit and to use this as security for the investment property (as well as the investment property mortgage itself).
Then when Tom finds his new main residence he will offer this as security for the investment property and the $100,000 will be released.
The 3rd example is probably the more common situation in which the cash as security is used.
There is a cost to doing this – When cash is used as security it will be in the form of a term deposit with an interest rate much lower than what the bank is charging. So, Tom may lose 3% in rate – get charged 5% for the loan, but receive 2% interest for the term deposit. There are tax consequences of this too as this would not be deductible.
But hopefully the use of a term deposit will be brief, and the benefits can last many years to come.
Only authorised deposit taking institutions will allow for cash to be used as security.
Written by Terryw broker at www.loanstructuring.com.au
Discussion at https://www.propertychat.com.au/community/threads/loan-tip-using-cash-as-security-for-a-loan.36038/