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Case Study - Investment Loans

Property investors Harry and Isabel Jensen are about to lose everything, their home, their three investment properties, and potentially their marriage; if only they'd been advised on how to protect their home from the bank when they set their loan up.

You see, their bank, like all lenders often uses something called the "All Monies Mortgage Clause" (AMMC) embedded in their legal documents, and it puts them in a commanding position.

So how did Harry and Isabel get themselves into this position?

Originally Harry got a loan from his local bank manager to buy his own home. About five years ago, after marrying Isabel, they decided to buy some investment properties. So, like most property investors, they went back to their bank manager who happily arranged a loan for "106% of the purchase price" for each of the properties to cover costs and deposits.

"Fantastic", they thought, "Just like we heard at all those seminars - build a property empire using none of your own money!"

After hearing about the dangers of cross collateralisation from a mate, Harry insisted on each loan being "stand-alone" and his bank manager happily obliged.

What Harry didn't know was that cross collateralisation was to be the least of his worries. It was the AMMC that was to be his downfall. His unawareness sowed the seed for a later catastrophe.

Let's look at how his bank manager explained the set-up of his loans:

This all looks fine - so where is the problem?

The AMMC threat is subtle and poses no immediate threat; and the menace can lay dormant for years, but it does give the bank the means to foreclose almost at will.

The way in which their bank structured their loans is actually quite different from the structure illustrated in the diagram above.

In reality, the bank, which already held the title to Harry's home, had simply thrown a net around his home and their investment properties to secure the total debt 'jointly and severally'. That's right; the bank now has the right under the AMMC to foreclose on any or all of the properties to repay all loans.

The bank has actually 'stripped' equity from their family home and applied it to the purchase of their investment properties in what is known as an 'equity transfer'.

Equity transfers are standard banking practice and has enabled mum and dad investors across the country to build a property portfolio, but it has also exposed them to unnecessary dangers. More about that and how to avoid the traps later...

Banks won't lend 106% of the purchase price against a property without a much higher interest rate and a huge mortgage insurance fee (which, by the way, only covers the lender... not you - you pay the premium for their peace of mind!)

As you can see in the diagram below, the bank has actually stripped a whopping $273,000 from Harry's home to secure the loans used to fund the purchases of their investment properties.

Unbeknown to Harry and Isabel, the loans on their investment properties are actually limited to 80% of the value of each property, (80% LVR), a comfortable $1.25 security for every $1 borrowed.

To meet Harry's demand for stand-alone loans, the bank simply split the loans into deductible and non-deductible sub accounts.

Their bank stripped $273,000 from the equity Harry had in his home to cover his 20% 'hurt money' he and Isabel were (unwittingly) required to contribute, plus purchase costs. They were totally mis-led into believing the bank was actually lending 106% against the investment properties.

But it gets worse for Harry and Isabel, much worse.

Under the AMMC, the family home's 'exposure to debt' (that is the debt their home is liable for), rocketed from $325,000 to a massive $1.438M, nearly 60% higher than the value of his home.

And Harry had no awareness of what the bank had done, and neither do most investors who borrow money for investments with the same lender as they have for their home.

Suddenly their home is at the mercy of the bank. And, they had no idea as the bank manager had never explained the effect AMMC could have on their own home. Little wonder - a recent survey of bank managers found that less than 25% understood the implications of the AMMC.

What triggered Harry and Isabel's catastrophe?

Life had been pretty good for Harry and Isabel, so they decided he would take his long service leave so they could travel for three months.

Harry arranged direct debits from their savings account to cover the repayment shortfall after rent.

It was while Harry and Isabel were overseas that disaster struck. One of their tenants lost his job and missed a rental payment creating a shortfall in the repayment of $1,170. The bank automatically issued a default notice demanding immediate payment.

Unaware of the events that were unfolding at home, Harry and Isabel were trekking towards "Base Camp" in the Himalayas.

Six weeks later they arrived home, exhausted, but exhilarated from their epic journey. The next day they started to wade through the mountain of mail that had accumulated over the two months they'd been away.

Upon tearing open the first of a number of letters from Harry's bank, his blood ran cold as he scanned the headline "Notice of Default". He scrambled to rip open a second letter from his bank as beads of sweat appeared on his forehead. This time the headline in red screamed "Letter of Demand - immediate payment required."

By now their loan was two months in default and the third repayment was due in just 5 days.

Terror set in as Harry scrambled to find the statement for their savings account. He found it was overdrawn by $2,751.28. He then fumbled for to find their credit card statement; it was just shy of its limit.

Including default interest, they were now nearly $4,500 behind in his payments. Their savings account was overdrawn and their credit card was nearly 'maxed out'. They needed over $7000 immediately. Where were they going to find that sort of money?

Their loans were now in default. If all requirements of the order were not met within 28 days, the provisions of the All-Monies Mortgage Clause provided that ALL loans would be 'deemed' to be in default and would be called up or action taken to sell any or all of the securities, (properties), including their home to recover any outstanding loans. Remember, the bank is exposed to a single client for in excess of $1.4M, so alarm bells were ringing... and loudly.

Harry and Isabel's predicament was now dire. It proved impossible to liquidate these investment properties within 28 days and equally impossible to secure new finance while in default.

One tenant losing his job had cost Harry and Isabel their $1.9M portfolio, including the family home in just a few short months.

The worst was to come... their relationship was at breaking point as they faced their financial ruin.

Identify what mistakes were made by Harry and Isabel that might have been prevented had they sought assistance from a broker skilled in structuring finance for property investors.

Discuss the legality of banks using 'All monies mortgage clauses' for investment property financing

How should Harry and Isabel have structured their finances, after taking appropriate advice from an independent broker?

How should investors ensure their investments are structured correctly? In other words, what should they monitor?

\begin{tabular}{l} Family \\ Home \\ Value $950K \\ Home Loan $325K \\ \hline \end{tabular} \begin{tabular}{l} Family \\ Home \\ Value $950K \\ Home Loan $325K \\ \hline \end{tabular}