Should you aim to avoid Lenders Mortgage Insurance (LMI) or leverage a lower deposit to enter the property market sooner? This guide breaks down the pros and cons of both strategies, using real-world examples to highlight their impact on your returns and portfolio growth. Find out how smart leverage can help you achieve financial freedom through real estate investing.
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Should you use a lower deposit amount to go and purchase property, or should you go in, avoid LMI, and pay a 20% deposit?
In this article, I'm going to go through my whiteboard, show you a couple of examples, and explain exactly what the effects of a lower deposit versus a high deposit would be when it comes to Australian real estate.
If you're interested, definitely keep reading.
Now, what we're looking at is the effect of a lower deposit and which one is actually going to work out better for us. When we go ahead and pay a 10% deposit, we incur something called Lenders Mortgage Insurance (LMI).
When you are paying a 20% deposit, you avoid this, and this is effectively an extra payment that you need to make as part of insurance to say: Well, look, I'm not putting a 20% deposit down, but here's my insurance that I'm paying for in case something goes wrong.
Effectively, you have two ways you can pay this:
Let’s say the LMI cost is, say, $7,000. You go: No worries, I'll borrow 90%, so I'm only putting 10% down, and then I've paid $7,000, or whatever the amount actually works out to be.
You could think if it's $7,000, for example, you would say: Well, $7,000 is my LMI amount, and let's say the loan amount is $400,000. You then go, 'My new loan amount is $407,000.'
Now, the advantage of this is that you don't have to have the upfront cash.
However, some people say: I don't really want to pay that upfront, and so I'll end up putting it into the loan, and people will go on to argue and say: Well, you're paying more interest over the 30-year period by putting it into the loan.
The counter to that is to get into the property first.
You can always refinance, you can always go and extract equity, you can always pay down that debt earlier after the fact. But if you're being held back from entering the property market because you want to avoid LMI, I think as we go through this article, you're going to realise the importance of leverage and being in the market for longer periods of time.
Now, let's figure out if it's actually worth the extra cost.
The example we're going to use here is for a $500,000 home.
Now, if you use a 10% deposit, that would be $50,000, but if you use a 20% deposit, it would be $100,000.
You also have some upfront costs when you are going and purchasing a property. So, you might have things like:
In this case, it would work out to be about $35,000.
Therefore, in order for you to purchase this property, you can go ahead and say a 10% deposit being $50,000 plus my upfront cost of $35,000.
In total, it's $85,000, or on the 20% deposit, it's $100,000 plus $35,000, which is $135,000.
If that all made sense with simple maths, definitely go smash that like button.
Now, we have another question, and that is: Can you actually borrow more?
What I mean by this is that you might be in a position where your maximum borrowing capacity only allows you to buy one property. In that case, if you do have a 20% deposit, it probably makes sense to pay the 20% and avoid LMI, an unnecessary cost, because it's not exactly like you can use the extra 10% and go ahead and purchase another property.
You could go ahead and just say:
Alternatively, if you have the capacity to purchase up to two or three properties, then we could go ahead and discuss what that looks like by avoiding paying 20% and instead paying 10%.
At 20%, we would have a $500,000 home that we control.
If we went in and said: I want to put a 10% deposit down, I can now control two of these homes at $500,000 each.
What I mean by that is the $100,000 can go into one property, or $100,000 can be split into two fifty-thousand-dollar deposits, and you would be able to go and purchase two properties.
Now, keep in mind, if you did go down this path of purchasing an extra property, you will have to pay an extra $35,000 to be able to go and pay for the upfront cost. (Just something to keep in mind that it's not just about the deposit amount; it is about upfront costs as well.)
In 2023, you purchase a five-hundred-thousand-dollar home, or you can go ahead and purchase a one-million-dollar home. So, if we go and take a conservative 5% growth rate, what would that be worth in five years and in 10 years’ time?
Again, when it comes to real estate investing, five- and ten-year timeframes are short-term. When you're looking at longer-term, it's 20 years plus.
In this case, in 5 years, your property should be worth $638,000.
In 10 years, it should be worth $814,000.
However, if you had one million dollars' worth of real estate and you've got two properties, then it would be worth $1.27 million, and then in 10 years, it would be worth $1.62 million.
Now, that's the value side—that's the value of these properties that you now control. So, what about the debt?
Let's go through the example.
On a $500,000 home at an LVR of 80—which is just your loan-to-value ratio—at 80% means your debt is $400,000. Now, after 10 years, if you decided to go interest-only and never pay your debt down, you could go and refinance after a five-year period of interest-only to get another five years. Your debt would still stay the same.
However, your value now has gone up to $814,000, so your LVR position naturally decreases over time because the value of your property increases, which means you now have $414,000 in equity. That would mean roughly making about $40,000 worth of equity on just this one property every single year, which is absolutely nuts.
To better understand the idea of not having to pay down your debt, I'm going to use an example like a property in Sydney.
You go ahead, and you purchase a property in Sydney, say, 30 years ago. It could be in the western suburbs; it could be in the eastern suburbs. But let's say you spent $200,000 for a home 30 years ago.
Now, if you went ahead and bought it at a 100% LVR, so you got a 100% loan, then that debt would still be $200,000 today.
However, the value would be significantly higher—it'd be worth closer to about $2 to $3 million, and your debt relative to that would only be worth about 10%.
This is why, if you understand the compounding nature of capital growth as well as how inflation devalues your currency, you'll understand why debt is actually the real asset when going and building out wealth.
Now, that's the example with a $500,000 property at 80% LVR. But what happens when we go and purchase a one-million-dollar property at an LVR of 90?
Now, 90% because we're only putting a 10% deposit down. So, in this case, it would be a $900,000 loan.
After 10 years, the debt would still be $900,000, but the value is now $1.62 million. The LVR position would be about 55%, and the equity we would have made would be $720,000, which roughly means $70,000 every single year.
That money is tax-free because it's actually equity.
You're not actually going and accessing that money; it's just your property value increasing over time.
Now, you can understand that if you've only done this with, say, one or two properties, you're still doing really well.
To be able to go and increase your net worth by $40,000 to $70,000 every single year moving forward is absolutely nuts.
Now, some years will be higher, and some years will be lower. That's why it's averaged out to be about 5%, which is actually quite conservative.
However, this should make you realize how important it is to be in the right real estate and the right investments. Because if you can go ahead and do this, it means that you have a machine in the background that keeps growing.
This means that you can start enjoying life—not having to save every single dollar.
You have an abundance mindset.
You go in and upgrade your lifestyle, and this, in turn, means you're happy as a person, and in turn, you have better relationships in your life, and you're able to actually make more money.
Therefore, if you go and do that, then you're able to grab that money, put it into the machine, and have that machine keep growing.
This means in 10, 20, 30 years' time, when you want to have a choice of not working or potentially taking up a job that, you know, may not pay as much, you don't have the stress of going: Oh my God, I can't because I haven't been saving money all this time. I can't take a lower-paying job because my lifestyle costs too much.
No, because you made the smart decisions early. And that is the compounding nature of this growth.
Let's have a look at this. If I want to figure out what my cash-on-cash return is, what would that look like?
What cash-on-cash return means is, for every dollar I put in, what's my return?
If I go to the bank today and say: Well, look, I'm going to put a dollar in, what's my return?, They're probably offering about five percent as a term deposit savings rate. So my one dollar generates me five percent.
Over time, it compounds and would work out to be higher than five percent, but for me personally, it's not worth my time. Instead, if I used a 20 percent deposit and you calculate all the upfront costs being $135,000, after 10 years it would have generated me $414,000 as equity. Then my cash-on-cash return would be 306%. This means, for every dollar I'm putting in, I'm going to make about three dollars.
This is very different from when you go in and say: I'm going to put a dollar in, and I see that growth in the share market might be seven percent, but it compounds over time, and you're getting nowhere near these sorts of returns.
The same thing can be said when you do it for, say, something like crypto.
Obviously, with that, you could have a compounding return depending on when you get in, what time of the cycle, and what you invest in, which could be much higher than Australian real estate.
However, we need to understand, with both crypto and Australian real estate, you're taking up more risk.
As you go and increase your risk, your returns hopefully should be able to give you that. If your risk profile says: I don't want to do those things, then you're probably better off going into things like Exchange-Traded Fund (ETF) to reduce your risk and diversify.
I'm definitely not a financial advisor, so I strongly urge you to do your own research and understand what product works best for you and why it works best for you. You're not in the same position as me, so it might not be the same things that we're looking at. Plus, our goals might be different.
Equally, you don't want to be listening to someone on TikTok who says: Oh, well, you can invest this much, and in like 40 years, it's going to be worth this much, because they don't cover off one main topic: that it's actually not going to be worth that much in 30 years' time.
Now, let's look at the 10 percent deposit. So we're still using the same $100,000, and we've also got the $35,000 like the first example, but we also have an additional $35,000 we need to put into this deal because we're buying two properties.
In this case, our total cash outlay is $170,000, and after 10 years, we will have generated $720,000. That means a cash-on-cash return of about 423%. That means, for every dollar, I'm making $4.23, and this is significantly higher than the first example, being 306%.
This is only on a 10-year timeframe. I can promise you now that when you extrapolate this out to 20 years, 30 years, and 40 years, these numbers are absolutely berserk.
It pretty much reminds me of that advertisement we would have seen for super that says: "Same age, same super," and then one goes up the escalator, and one keeps walking down. That's pretty much what I'm seeing here. I probably butchered that ad completely, but you get the idea.
Now, although the counter to all of this is: Well, I'm purchasing two properties. Do I double my risk? With interest rates so high, can I afford to pay for one mortgage? What happens if they're both negative cash flow? I need to pay for two mortgages.
These are the considerations you need to keep in mind because the reality is, you need to do things in line with your risk profile.
It might be that you can afford to buy two, but you might just buy one. If you just buy one, see the results, and you're able to manage everything, then you might find the confidence to be able to go on to your second, third, and fourth.
Essentially, when people come to us, they're saying, "Look, we want to build out the portfolio over the next five to ten years, but let's start with one."
This is what I always bring it down to: I can talk to you about big numbers and big goals, but until you go and take that first step, you're essentially not moving at all.
Therefore, execution is very important. If you need help, book a FREE discovery call with my Search Property team.
Thank you so much for reading, and I'll catch you guys on the next one!
Disclaimer: Search Property Pty Ltd (SP) does not provide financial or investment advice and does not hold a financial services license as defined in the Corporations Act 2001 (Cth). Any advice given by SP is general in nature and does not take into account your personal circumstances or objectives, financial situation or needs.
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