Finance Readiness

It pays to get fit!

 

When considering starting your investment journey, it pays to be financially fit. It’s time to start preparing well ahead of an application to any lender.

Lenders are in the business of lending money and making a profit, and so they are very conscious of minimising their risk.

They are looking for financially responsible applicants. They have statistics to prove that certain behaviours, trigger more loan defaults. Using this data, they have become more analytical in the assessment process.

How do you become a preferred loan applicant?

Start your preparations six months before you apply for a loan:

 

Pay your bills on time, avoid overspending, and demonstrate financial discipline (there’s the ‘delaying gratification’ idea again!) by saving consistently.

Pay your car loans, personal loans and existing mortgages on time. Dishonour fees and reversals are regarded as defaults.

Credit cards – avoid going over the limit. Late fees and exceeding your limit is assessed as delinquent behaviour when conducting a home loan assessment. Most lenders require a copy of recent credit card statements as part of the required supporting documents accompanying the loan application.

Select a credit card limit that you can repay in full monthly to avoid interest charges- it demonstrates to the lender that you are not living beyond your means. When the lenders assess your home loan application, high credit limits absorb some of your available funds for servicing other loans. Your loan serviceability is evaluated on the limits of the credit cards, not the outstanding balance. Reduce your credit card limits where possible to increase your borrowing capacity.

Pay your Council Rates on time, any arrears shown on council rates notices affect the evaluation of the loan.

Phone, gas & electricity accounts – make sure you talk to the providers if you have a dispute. Utility providers will place a default on your CRAA (Credit Reference Agency of Australia) when the account remains unpaid. If this occurs, you will have problems when applying for home loans, and your application may be declined. A default remains on your CRAA for five and in some circumstances, seven years.

Avoid overdrawing on your everyday transaction account. Make sure you have sufficient funds to cover all withdrawals otherwise delay the transaction that will take you into an overdrawn balance until you have adequate funds to cover the purchase or withdrawal. Regularly monitor your balance via the internet.

Never submit multiple loan applications for the same loan. Each application submitted is recorded on your CRAA report, even if you do not proceed with the loan. The lenders and mortgage insurers access your CRAA report for each loan application. The CRAA report is held by an agency that records all loan enquiries in Australia within the previous five years for every borrower. Simultaneous duplicated loan applications can result in a decline that may not have occurred had you just submitted one loan application.

Start a savings program to demonstrate that you can live responsibly and within your means and that you have spare funds to service the repayments on any new loan.

Any additional repayments on existing loans are also viewed favourably and display responsible financial management. Parts of your deposit can come from sources like gifts, financial windfalls or inheritances, but most lenders will want to see at least 5% coming from genuine savings. Genuine savings are funds you’ve held in your account for at least three months.

Lenders will need to examine your work situation to determine that you have a steady source of income. The way your income is assessed will depend on your type of employment. They are looking for consistency and reliability of your income-earning capacity. Changing jobs just before applying for a loan or during an application process (even after pre-approval) may mean being disqualified. (Exceptions apply if the job change is within the same industry or is a promotion with higher pay).

Similarly, you should avoid making any new applications for finance before the lender funds your loan Рdoing so may take you back to square one! Always check with your financial representative as to what the policy regarding new credit is and what effect it may have on your approval.

The purpose of the loan is important too. If the loan is for investment in property, the rental income will be considered and assist in boosting your borrowing capacity. Lenders will ask for a rental appraisal from a registered agent. If the agent provides a rent range, the lender will work on the lower figure.

Good credit habits will enable you to grow your wealth more quickly, and you will be a preferred loan applicant when borrowing to purchase property to either occupy yourself and or to build an investment portfolio.

Having access to a specialist broker, who is conversant with the different lender’s criteria for assessing applicants is crucial. You may be familiar with your bank, perhaps one of the ‘big 4’ but remember you are subject to their specific benchmarks and there is no room to negotiate. Having access to multiple lenders means finding the right fit for your circumstances.

Given the tightening of lending criteria over the last few years, engineered in part by the prudential regulator’s requirement for ‘responsible lending’, the burden of proof has escalated to new heights.

Be prepared to supply lots of detail and paperwork.

You have to ‘jump through more hoops’ than ever before, but if approved, you can consider yourself, indeed, ‘creditworthy’.

 

Asset Classes

Assets can be broadly classified

as either

 

DEFENSIVE or GROWTH

We have seen so far that scarcity requires us to make choices about the satisfaction of the competing needs we have in life. Increases in productive capacity imply a more satisfactory answer to the economic problem. More capacity means more employment, more income and more tax revenue.

To increase potential satisfaction, or make the economic pie larger, it is necessary to devote some resources to investment.

(*Implies a more satisfactory answer because it very much depends on how the additional income/goods and services are distributed but that is the realm of normative economics and a different discussion!)

In a specialized economy, we have our income to satisfy our needs first and then wants, via discretionary spending.

Once you have paid tax, you then have the choice to either spend or save your disposable income.

If you are in a position to save and decide to invest, you then have to determine how to make your money work for you.

There are four main asset classes.

They can be broadly classified as either DEFENSIVE or GROWTH assets.

Defensive assets focus on generating an income. There is minimal risk involved, and so the returns are very modest. They are appropriate for those who are very conservative and are not in a position to risk losing any of their capital, e.g. the elderly. Examples are Cash and Fixed Interest securities.

Assets can be financial, paper assets such as bank accounts or shares (pieces of paper that ensure ownership). Assets can also be classed as real, or tangible such as property.

DEFENSIVE ASSETS:

  1. CASH – deposits in the bank that earns interest, typically at a base rate. The investment is highly liquid, that is you can access it at any time. Therefore the financial aggregators, the banks and financial institutions generally, have less certainty about what they can invest the money in and for how long and so are only prepared to pay lower interest. Depending on the time value of money, influenced by the inflation rate, cash in the bank may lose value over time as buying power diminishes.

 

2. FIXED INTEREST – Fixed interest assets are loans to companies (debentures) and government (bonds). They are similarly low risk, though slightly more risky than cash and the returns are a little higher since they are for a fixed term, giving the holder of the security more certainty. Because the term is set (anywhere generally from 1-5 years) these are less liquid assets.

GROWTH ASSETS

Growth assets focus not only on generating an income but also on capital growth, or an increase in the value of the asset over time. The trade-off is that the investor needs to be prepared to ride out any volatility in the market or at worst, suffer a capital loss. Time in the market is more important than timing.

3. PROPERTY – investment in property either indirectly or directly is deemed a growth asset as it not only generates income but also over time, capital gain. Bricks and mortar is a tangible, real asset and isn’t subject to management performance, the returns are contracted in a lease agreement, and the government provides substantial incentives to encourage the supply of and demand for housing. Real estate as an investment lacks liquidity, but capital doesn’t tend to be at risk- volatility in house prices isn’t usually pronounced. There are relatively large entry and exit costs and the asset class suffers the disadvantage of indivisibility.

4. SHARES – Shares can be very profitable, but they carry the highest risk of this asset class. Shares are proportional ownership in a company, and as such are subject to the performance of the management, this may be excellent, or it may be lacking. Your investment as a shareholder may be at the mercy of personality, individual talent or outright bad behaviour!

Their value is dependent on the performance of the company in the broader context of the economy, exogenous influences like the demand for our goods and services internationally and the management style of individual CEOs and Directors.

Shares are an asset class that provides low-cost entry and liquidity. Given the ease at which shares can be sold, they provide the investor with an opportunity to realize gains progressively or cash in should circumstances change.

However, given the ease of entry and exit, they are also more volatile – investor expectations can become a self-fulfilling prophecy.

In a global economy, international shares are riskier still as they are subject to currency risk – fluctuations in either currency may impact the returns.

Example: If an Australian based investor is expecting USD 10,000 as a return on investment, it may translate into AUD 20,000 if the exchange rate is USD 1 = AUD 2,

BUT if the AUD appreciates to equal to the USD, the return in AUD will be reduced to $10,000. ($1AUD=$1USD)

PROFIT is the return to RISK. The more risk you are prepared to take, higher are the potential returns. Any investment choice needs to be evaluated, taking into account your particular circumstances and stage on the income/life cycle.

Diversification is also a golden rule of investment, that is, not putting all your eggs in one basket’!

Diversifying spreads the risk and helps smooth out volatility across a portfolio.

Different people also have different appetites for risk.