I have written recently of the sometimes troubled relationship between banks, borrowers and regulators. Indeed, hardly a week goes by without some fresh allegation of wrongdoing, consumer complaint or a misguided call for an enquiry.

As we rush toward the dubious title of most over regulated and over governed country on the planet I think we risk missing the point.

In our business we are often approached by new and existing clients who have a perceived problem with their bank. In some cases and despite our best efforts to educate borrowers simply don’t seem to understand how banks work. It’s a recipe for misunderstanding at best and disaster at worst. I can’t see how ever increasing legal and legislative obligations on lenders and intermediaries is going to solve this problem. In fact, with more regulation comes increasing and ever more complicated disclosure and compliance which just leads to more paper, more loan clauses and in my experience less chance of the borrower actually reading and digesting all the information.

Let’s cut to the chase. Despite what the politicians, bleeding hearts and leftie do gooders might think the banks are not out to get you. Banks are interested in making a profit, not lending you money on the basis of some sinister plot to send you broke. Granted most banks have serious communication issues and couldn’t speak plainly if you held a gun to their heads however in my mind that’s beside the point.

Ultimately for a borrower the primary communication you need to understand when you borrow money is the bank’s Letter of Offer. Your rights and responsibilities and those of the bank are enshrined in this document and its best that you understand the content. Most of the document will be standard bank jargon but there are a few specific clauses that you really need to take note of. When we see disputes between borrowers and banks it’s generally a result of misunderstandings in these key areas.

In no particular order here a few tips for the unwary:

Loan Term and Interest Only Periods

The bank will provide the loan over a specific term. If it’s 15 years with the first 3 years interest only you will go to P and I repayment after 36 months. It’s your responsibility to approach the bank early if you want more interest only. If you don’t the bank will do exactly what was agreed from the outset and commence P and I payments. It’s that simple and frankly I can’t believe the number of borrowers who seem surprised when the bank acts in accordance with what was agreed.

Some banks offer a short loan term of say three years. The loan expires at the end of the term and must be renegotiated prior to the expiry date or paid out. Make no mistake, this is not the initial term, it’s the total term. Again, if you want to extend you need to get in the front foot and negotiate the extension prior to expiry. Banks hate expired loans and some charge penalty interest so beware.

Performance Covenants

When the bank lends money it does so on the basis of certain key metrics. These include the capacity of the borrower to meet their obligations and the security coverage and gearing provided by the assets the bank takes a charge over. The Letter of Offer will include certain benchmarks that the borrower needs to meet in an ongoing basis. There will be reporting obligations for the borrower should they become aware that they are not meeting their covenants.

Some of the more common performance and reporting requirements will relate to units in a letting pool, renewal of leases for motels, interest coverage and debt coverage benchmarks and minimum maintainable net profit. Put simply, the bank wants to know if things are not going to plan. Here’s a tip, in my experience banks are far more likely to bend over backwards to help a client who puts their hand up than one who hides the bad news for as long as possible. If you don’t want to raise your concerns with the bank raise them with us first and let’s see if there is a strategy for managing the situation.

Annual Reviews

Most business loans are subject to annual review. The review date is outlined in the Letter of Offer and is almost always on the anniversary of the loan. It’s important to know your review date and be prepared for it. As a minimum the bank will want your last twelve months financial statements, most recently lodged tax returns, an up to date statement if assets and liabilities and confirmation from your accountant that your ATO obligations are up to date. Turn up early with all this documentation and, once your banker recovers from the shock, you will certainly be extremely popular. Annual reviews used to be the bane of my existence back in the day and I reckon not much has changed. Chasing borrowers for overdue documentation while convincing the credit manager they are really good people is no fun!

Valuations

Banks worry about the value of their security and rightly so. For most of our clients that security value is directly related to the value of the going concern and thus the financial performance of that business. At annual review don’t leave that assessment to the bank. As part of your annual review put forward an adjusted profit and loss in a form consistent with your original purchase. Provide some recent market data and make the argument that if anything the business value has gone up. The trap here is that if the bank uses your tax returns to assess the business value at review time there will surely be grief. The bank could even insist on a revaluation by a bank panel valuer which is an expensive process and in my view rarely worth the trouble if solid data is to hand. Remember though, under most loan conditions banks can revalue security at any time at your cost.

Finally, a word on pricing. Business borrowers are charged an all up interest rate which is made up of a base rate, a liquidity margin and a client risk margin. It’s mostly smoke and mirrors but the risk margin is worth thinking about. If you believe your risk to the bank has diminished since you took the loan ask about a rate review. Nothing ventured nothing gained as they say.

Of course, our clients have the added benefit of our assistance and advocacy throughout the life of the loan. That includes taking the time to explain why the banks do what they do even when they aren’t that sure themselves. We also help with annual reviews and interest only extensions. When managing these matters I am often reminded of a great quote from Winston Churchill
……………..”If you are going through hell……. keep going!”.

Mike Phipps F Fin
Director | Phippsfin Pty Ltd

I have written previously about interest only finance and particularly the pros and cons of such a strategy. Setting aside the current pressure on lenders to restrict interest only funding I think it’s worth having a broad look at interest only finance, why borrowers and advisors advocate these strategies and why they may be wrong.

In this article we will talk about interest only finance in the context of money borrowed to acquire an income producing asset such as a business or investment property. The central premise is driven by current taxation rules which essentially allow interest costs associated with a loan to acquire an income producing asset being tax deductible.

The on flow effect of this rule gives rise to the concept of negative gearing, a term which essentially reflects a situation where the income from an investment is less than the interest on the loan used to acquire the asset in the first place. This strategy is most commonly seen in residential and commercial real estate investments. Let’s say you lose $10,000 in a financial year and your top marginal tax rate is 30%. You claim the loss against your taxable income (usually a salary or business profit) and the tax man puts in $3,000 while you put in $7,000. As you can see, at this point negative gearing for its own sake is looking like a mugs game. However, all is not lost. Provided your asset value rises by $7,000, you are at break even. Without the capital gain you are spending a dollar to save 30 cents, which doesn’t sound too attractive to me. In fact, even with reasonable capital gains to offset your holding costs you may find, after selling the asset and paying capital gains tax, that the whole exercise was a financial waste of time.

What we can see is that the relationship between debt levels and asset values has to adjust over time for borrowing to invest strategies to make sense. Obviously capital growth is one way albeit the investors ability to influence the value of the asset will be determined to a large degree by the market more broadly. The counter position is to pay down debt and thus control the dynamic and the asset value / debt level ratio. I acknowledge that over time the tax benefits will reduce as debt and interest costs fall and hopefully income rises. However, the simply beneficial outcomes of amortising debt can’t be overstated.

Obviously as debt is repaid interest costs fall and profit from the investment rises. As we can see from the example above regardless of your tax rate every extra dollar in your pocket will contribute to a better return. That may not equate to improved cash flow because you are using additional funds to reduce debt however, as that loan reduces your capacity to amortise debt improves exponentially. Put simply, more of your repayments go toward paying principal and less to meeting interest.

An important risk and wealth management benefit then ensues. You start building equity in your asset which not only contributes to your net worth but also hedges against possible unforeseen economic conditions such as asset values falling and rising interest rates. In the long run your low or no debt asset can derive tax effective income or cash into your retirement

In business finance, interest costs are generally tax deductible albeit a negatively geared business won’t last long unless you have a stack of cash in the bank , strong external cash flows and a desire to burn the lot. Again, the benefits of future proofing your business by amortising debt cannot be overstated. Building equity buffers and reducing interest costs have long been core investment metrics for some of the most well regarded business people and investors world wide.

Am I saying that interest only finance is bad? Not at all, just as long as the borrower understands why the strategy is being employed. This brings us to the miracle of leverage. Put simply, if you can buy an asset returning 14% using bank debt at 5% then the higher the leverage (debt to asset value) the more money in the investors pocket. We see this dynamic at play in management rights syndicate transactions where 70% bank debt can derive 20% return on equity after interest for investors. Surely there can be no good reason to pay down debt and dilute such a cracking return by diverting cash flows from the investors to the bank loan. I would argue that taking a notional reduction in return to, say 15% and using the excess cash flow to pay down debt, build equity and risk proof the business makes very good sense indeed. Building a buffer for potential changes in bank gearing policies or asset value declines also saves a partnership the worry of needing to contribute lump sum capital at some future time.

Until recently my advice to clients was to take as much interest only variable rate money as the bank would lend and pay it back as fast as you can. The strategy builds a redraw facility war chest, creates notional equity via voluntary debt reduction and reduces interest costs. With banks starting to charge higher rates for interest only money and restrictions on paying extra on fixed rate loans, now might the time to modify your position and formally go to P and I finance. Your bank will love the idea and hopefully reward you with lower interest rates and more satisfactory loan terms, particularly at annual review.

Finally, for all you closet economists, wealth planners, tax agents, investment advisors, property spruikers Et al, I am not a financial planner and this is not advice. I acknowledge that this article oversimplifies a complex issue. It’s designed simply to trigger in the mind of a borrower the need to better understand why certain choices are made. And a confession, before Christmas I moved all my interest only property debt to formal P and I. Better rates, forced equity build and less money for cars…..gotta be a good plan !

Mike Phipps F Fin
Director | Phippsfin Pty Ltd
ACN 139 124 673

We have talked in the past about our view that we are moving into a tighter credit environment in which bank lending guidelines will become stricter. We also talked about challenges existing borrowers are having with annual business loan reviews and extended interest only periods. I am less than delighted to announce that for once our predications have come to fruition. Daily feedback from borrowers suggests that times are indeed becoming challenging both for new borrowers and for existing operators.

To be frank some of the concerns raised with us are of the borrower’s own making and reflect a lack of understanding of the terms and conditions of the loan. In many cases we have been able to offer guidance around a better understanding of loan condition compliance and offer borrowers a few helpful tips to manage their bank relationship better. For our own clients we offer to manage the relationship on behalf of the borrower which can reduce the stress levels somewhat. A problem shared is a problem halved so to speak.

Here’s what we know for sure. The majority of business loan borrowers are going to be subjected to an annual review of their facilities. The borrower’s ongoing capacity to meet their obligations and the value of the bank’s security are usually inextricably linked to the performance of the business. As such it should come as no surprise that the bank will seek copies of your most recent financial statements. By most recent we mean very recent, not your tax returns lodged 12 months ago. This may well mean that you need your accountant to prepare end of financial year financial statements even if you don’t intend to lodge your returns for months. I hear people say what an impost this is. I say that if you have got to the end of the financial year without preparing draft financial statements as part of pre June tax planning you need to take a serious look at how you are managing your financial affairs. I suspect your lender will take the same view. Nothing strikes fear into the heart of your bank manager like disorganised financial reporting and the possibility of ensuing dramas with tax planning and provisioning!

A word of caution on simply dropping your financial statements on your bank manager’s desk. Going concern businesses such as management rights and motels are bought, sold and valued on adjusted net profits. Your tax returns will seek to minimise that profit as best and as legally as you can. It’s important to ensure that your lender appreciates the difference and assesses your annual review in a balanced manner. Comparing an unadjusted set of financials designed to minimise your tax with the P and L you bought on and valued on can be a recipe for disaster if not managed and presented appropriately. Again, we do this for our clients if they wish.

Your lender will almost certainly ask for some supporting information when conducting the annual review. An up to date statement of assets and liabilities is a definite and in most cases so is confirmation that all your tax obligations are up to date. We believe in getting on the front foot and also providing your bank with any good news stories that will assist in keeping the lender in a state of happiness. If you have an agreement top up, lease extension, units coming into your letting pool, new accommodation contract or wonderful Trip Advisor reviews tell your lender.

And now, onto another challenge. It may be that your loan is not coming up for review but for expiry. This is a much more serious matter than the annual review of a loan and we have previously written about the potential perils of short term finance. Some lenders, in order to offer lower interest rates, make relatively short term funding commitments to their clients. The Letter of Offer says loan term 3 years. Many borrowers wrongly assume this is the interest only period and the loan will automatically roll on. Not so. If the loan term is 3 years then all bets are off after that period. In essence you reapply for your loan and there is no obligation on the bank to extend the loan term. It is imperative that you have your loan term expiry diarised and ensure you have all necessary information in front of your bank in time for them to reapprove the loan, revalue the business and other security and issue a new Letter of Offer. These days that’s no less than a month prior to the loan expiry date. If you miss the expiry date the bank can, at its discretion, extend the loan term to give you time to get yourself organised but it’s not a good look and best avoided.

Regardless of loan review and/or expiry triggers more and more banks are taking the option of revaluing security more regularly. Remember, your bank retains the right to revalue as and when they see fit and it’s at your cost. Again, get on the front foot with an adjusted P and L for sale purposes and some recent market sales evidence and potentially save yourself thousands.

So, what’s the end game here? Frankly we make money when people borrow and use our services. That includes refinancing so I guess we should be big fans of that strategy. Not necessarily. All things being equal you have likely developed a relationship with your bank, met your obligations and built trust and some rapport. There’s value in that relationship and like a marriage it’s worth working at, even if there are occasional rocky patches from time to time. However, when the time is right it’s certainly worth at least taking a look at the competitive landscape to see what else is on offer and to ensure your lender is looking after you. In my mind the time to do this is at annual review or loan expiry. Your bank will review you and I think you have every right to review the bank. You have gone to the trouble of preparing what amounts to a loan application (or we have done it for you) and in many cases you have an up to date valuation. It takes little extra effort to use this data to see what other lenders might offer and to compare your existing arrangements. At the very least you will be equipped with some bargaining power and at the other extreme you will have options if your current lender drops the ball. Our end to end process manages all this for our clients fee free (shameless plug !)

Right now, the single biggest motivator for people moving banks is the imposition of P and I loan repayments at the end of interest only periods. There are numerous reasons why borrowers like interest only and just as many reasons why lenders don’t. We have developed strategies for negotiating extended interest only terms or at least reducing the burden of full P and I repayments and we are happy to share these with clients.

A word of warning. Debt service tests are becoming ever more stringent and the hurdle you met 3 years ago may well be a leap too high in todays closely regulated financial environment. If you are asking for interest only finance, you need to have a good reason. Preserving cash flow for good wine, fast cars and fun times resonates with me but will almost certainly leave your bank manager less than excited. There are any number of perfectly good financial reasons to use interest only finance so best to use one of those instead.

Finally, and just to clarify because I know the managing director will ask. No, I don’t advocate taking a look at the competition to see what’s on offer if your marriage is getting a bit rocky. In my case that could prove fatal!

Mike Phipps F Fin
Director | Phippsfin Pty Ltd
ACN 139 124 673

There are lots of quotes on the internet regarding financial literacy. Here’s the one that jumps out at me:

“Financial illiteracy is not an issue unique to any one population. It affects everyone: men and women, young and old, across all racial and socioeconomic lines. No longer can we stand by and ignore this problem. The economic future of the United States depends on it.”
President’s Advisory Council on Financial Literacy

Here in Oz we have an interesting way of dealing with the problem of the financially illiterate. It’s a lot like the way we deal with dangerous roads. The problem is identified, usually by numerous accidents, and then we erect a sign warning of dangerous conditions ahead. We don’t invest in fixing the two obvious problems, being the dangerous road and the poor driver. Then we compel everyone to walk as slow as our slowest person by introducing draconian enforcement measures, fines and speed limits. It’s brilliant, just brilliant!

In the financial services sector, we do the same thing. A number of accidents and close calls results in a review of the system. This is followed by a raft of new rules and regulations, monumental amounts of paperwork and increased regulation. The whole farce culminates in a thing called The Banking Code of Practice. This inspired piece of nonsense not only compels lenders to treat clients like inexperienced drivers on dangerous roads but to also assume that the driver is impaired and incapable of making any kind of sensible decision. Best of all it places responsibility on the lender while giving the borrower any number of avenues to escape responsibility. There is no Opt Out provision for long suffering bank clients who simple don’t want mountains of paper every time they want to do something. We all walk as slow as our slowest and that’s a snail’s pace to be sure.

Needless to say, we are already seeing the outcome of all this new compliance and to date none of it is good for the economy. Slower loan approval turnaround times, lower credit approval volumes and very fragile consumer confidence. Sure, a few aggrieved bank clients are probably feeling pretty good about the whole mess but for the average quiet Australian in the ‘burbs it’s hard to see any positives coming out of the current situation. Even if we get real about financial education right now, we are at least one generation away from a population that doesn’t need government rules and regulations in order to make informed financial decisions. In the meantime, the job will be left to people like us who spend an incredible amount of unpaid time explaining to clients how things work.

Which leads me (at last you say) to a very brief summary of the most misunderstood finance related ratios and concepts that we see. Remember, we deal mostly in business finance so these will be somewhat tilted that way. Having said that understanding the rational involved in each concept will help anyone who wants to better understand finance.

Equity

Simply the proportionate value of an asset that you own. If your house is worth $800,000 and you owe the bank $300,000 then your equity is $500,000. That’s fine in theory but it’s important to understand that if you go to the bank, you can’t borrow an extra $500,000. For business and many investment purposes the maximum lending (or gearing) will be 80% of the house value. As such the calculation is:

• $800,000 x 80% = $640,000 less current debt $300,000 leaves $340,000

A lot of potential buyers of management rights and motels make this fundamental mistake and assume a higher level of equity than what is actually available. The only way to access all the equity in a property is to sell it.

Loan to Valuation Ratio (LVR)

Simply an outcome of asset value and lending. Sometimes referred to as gearing.

• Loan $300,000 divided by asset value $750,000 x 100 = 40% LVR

It’s important not to add purchase costs to the asset value when calculating LVR. It’s also important to understand that banks lend on purchase price or valuation, whichever is the lesser. If you pay more than valuation for an asset while needing to maintain an acceptable LVR you will need to contribute additional equity. That gets important later on, as you will see.

Interest

Lenders charge interest when you borrow money. The longer you take to pay down the debt the more interest you pay. If the net value of the financed asset or venture (after tax planning and deductions) does not appreciate faster than the cost of the debt you are behind the eight ball. It’s that simple. So, how to shorten the odds in your favour? Pay the debt off fast.

Incurring an interest cost with a tax deduction being the primary motivation is, of itself, a flawed strategy. Who in their right mind spends $1 to save 30 cents? There are good reasons to carry business and investment debt and tax deductibility of interest costs just happens to be a happy side benefit.

I strongly recommend using an Amortisation Table to review the loan you are contemplating. Plenty are available via Google and they are great way see graphically what a difference accelerated debt reduction can make to your total interest costs.

One caveat… there are some geared investment products for which cash flow generation is more appealing than debt amortisation. That’s fine as long as the leveraged investor understands the nature of the risk and the future possibility of a need to introduce more capital should the asset value fall and/or bank lending tolerances change.

Return on Investment (ROI)

An outcome of comparing the price of an incoming producing asset with the raw profit it makes. Not a bad way of comparing like assets and other investment opportunities.

• Net profit $320,000 divided by management rights plus unit price $2,350,000 x 100 = 13.6% ROI

This simple ratio can be used for any investment opportunity or asset class and in my view is a better method of comparing opportunities than using multiples of net profit. I am sure the smarties out there will point out that there are far more sophisticated ways of comparing competing investment opportunities. I am happy to write about Net Present Value of Future Cash Flows once I am confident the average borrower understands the fundamentals.

Return on Equity (ROE) and Leverage

You’ve got a certain amount of money to invest and the rest will come from the bank. Let’s say the asset has a ROI of 14%, interest costs at 5% and gearing at 70%. The simple outcome is that the more 5% interest only money you can get your hands on the higher your return on equity. Of course, blind Freddie can see that if/when interest rates rise the ROE will erode unless the ROI has been driven up by improved business performance. With rates where they are right now and asset classes like management rights showing ROI numbers at nearly three times cost of debt the miracle of leverage can be clearly demonstrated. Just remember, it’s only a miracle while rates are low, and ROI is high. Beware the miracle that turns out to be a mirage.

Here’s the basics:

• Asset value $3,500,000
• Add costs to acquire $250,000
• Total required $3,750,000
• Less bank finance at 70% LVR $2,450,000
• Equity contribution required $1,300,000
• Net profit $475,000 less interest costs $122,500 = $352,500 divided by $1,300,000 x 100 = Return on equity 27%

Seems simple and wow, what a return! Problem is this calculation is flawed and reflects the way numbers can be presented to distort outcomes. The calculation reflects a profit net of a two-person team and net of any allowances for contingencies such as relief management. To get a real-world ROE these allowances must be made. As such the revised calculation looks like this:

• Net profit $475,000 less interest costs $122,500 = $352,500 less wages and contingencies allowance $130,000 = $222,500 divided by $1,300,000 x 100 = Return on equity 17%

Still pretty good but certainly not the 27% the raw numbers would suggest. The trick is to understand that ROE needs to be seen as a passive return. That is, a return after the personal labour and contingencies allowances of the business owner are deducted from the profit. My personal preference would be to take a lower return (still way better than my super fund for example) and pay off the debt.

We tend to use the ROE calculation when assessing a passive investment, but you can also use this when you are looking at the returns a husband & wife business is generating. To calculate your ROE, first you need to ask yourself what you would reasonably pay yourself to complete the work you are doing & deduct that from the net profit, then you can truly see what the return to you for your original investment would be.

If all these ratios are starting to give you a headache, remember… we are always happy to run all the numbers for you and our services are fee free.

In closing I must stress that all this is very simplified, and every borrower will have a different set of circumstances. Clever tax planning and individual asset classes will also impact my observations. Borrowers should always consult their accountant before making any financial decision.

Let’s hope that at some point we can all start walking at our own pace.

Mike Phipps F Fin
Director | Phippsfin Pty Ltd
ACN 139 124 673

The character Polonius counsels his son Laertes before he embarks on his visit to Paris. He says, “Neither a borrower nor a lender be; / For loan oft loses both itself and friend.” It means do not lend or borrow money from a friend, because if you do so, you will lose both your friend and your money.

Polonius is a character in William Shakespeare’s Hamlet. He is chief counsellor of the king, and the father of Laertes and Ophelia. Generally regarded as wrong in every judgment he makes over the course of the play.

I write this month’s steam of consciousness ramblings at 20,000 feet on my way home from New Zealand. Over the past few years I’ve become quite enamoured with the land of the long white cloud. Apart from the obvious downside of the place being full of kiwis, it’s a decidedly pleasant and laid back destination.

This trip entailed 5 weeks roaming around parts of the South Island with a spot of hiking, tramping, skiing and eating thrown in. They take their alpine treks pretty seriously in NZ with magnificent scenery and equally impressive huts to stay in overnight. They seem to also have a great fear of avalanches judging by the signs, but I guess that comes with the territory.

I was on one of these hikes with plenty of time and solitude when my mind turned to you, dear reader. Well, not you specifically, more the dreaded deadline for this article and more importantly, what the hell would I write about this month. This random thought led to debate in my head about the nature of debt. When I say in my head, maybe it was out loud but there was no one around to hear me, so I’m not officially crazy.

Signing ContractHere’s the thing. We all borrow stuff. No money changes hands but there’s an implied contract that the borrowed item will be returned in a reasonable time frame and in the same condition it was in when borrowed. “Mate, can I borrow the ute?” has an implied agreement that it will be back before nightfall with a full tank of juice and at least an attempt at a clean. Same goes for mowers, although I think the habitual mower borrower needs a stern chat and directions to Bunnings.

I’m filling in my immigration card on the plane and the bloke next to me asks if he can borrow my pen. Sure. We both know it’s coming straight back.

Now, I need to get some serious work done requiring all manner of manly devices. So, I go to Kennards. “Mate, can I borrow a chainsaw, a scissor lift and a box trailer?”. Not a chance but you can hire them. Here’s our terms and conditions, sign here and whip out the credit card.

Ah ha! So, you borrow off your mates but you hire stuff when you have to pay and there are formal rules. So why do we borrow from banks I wonder? Surely if we are asking for the use of an asset that we are expected to return, on a formal basis with commercial terms involved, we are hiring, not borrowing. Of course, the beauty of hiring money from the bank is that you don’t have to give it all back at once (*usually, see side note below). Just pay the hire fee (interest) and return the asset over an agreed time frame.

Sounds like a pretty good deal to me. Imagine if I tried this with my friends at Hertz. I’ll need the car for a week and then I’ll drop the back left hand door in. In a couple more weeks the gearbox, and so on. In the context of most hire arrangements this bank money caper looks pretty accommodating.

Yes, I am playing with an idea, but the core of my point is this. If we stop thinking about debt as borrowings and start thinking of it as money we have hired then maybe we will take more care in terms of what we do with the dough. And maybe, just maybe, the average borrower will appreciate that just like the mates ute, it needs to come back in the same nick it was in, clean, tidy and with the fuel gauge on full.

Can you imagine any fair minded Aussie bringing the ute back filthy dirty, a week late, an empty tank and a ding in the tailgate and then blaming his mate because he should have known he never looks after stuff?

Me neither.

*A word on loan terms.

Banks will hire (lend) you money over a specific period of time. For the average punter buying a house that’s 25 to 30 years. Sometimes there’s an initial interest only period followed by a period of debt amortisation also known as P and I payments. Business finance approvals can often have a much shorter term, 3 years interest only for example. Many borrowers think that’s 3 years IO followed automatically by a term of P and I. Not so. If your Letter of Offer says 3 years then 3 years it is. At the end of the term the loan expires and is technically fully repayable. That’s known as a refinancing risk and it’s often offset by the shorter term loan having a lower interest rate.

Also, it’s worth understanding that your capacity to repay a loan is calculated on the total notional term less the period of interest only you have. As such the longer the interest only period the more onerous the debt servicing hurdles become. If the longest term you can have on a business loan is 15 years and you take 3 years interest only you need to be able to demonstrate a capacity to pay off the debt over 12 years.

Mike Phipps F Fin
Director | Phippsfin Pty Ltd
ACN 139 124 673

Before we begin………………

To pull a rabbit from a hat.
“to do something very clever and unexpected that solves a problem.”

To get one’s ducks in a row
“to ensure all of the small details or elements are accounted for and in their proper positions before embarking on a new project. In written form, most believe the term originated in the 1970’s. But at least one article has been found where the term was used as early as 1932.”

What strange days these are. Not that long back our business was booming, and new loan approvals came thick and fast. In fact, the loan approval was scarcely cause for celebration as we run like hell just to keep up with demand.

As of today, business is ok but no records being set. New loan approvals are met with a mixture of elation and relief and we are running ads suggesting that getting a deal approved is akin to pulling a rabbit from a hat. In truth it’s not quite that difficult but the marketing theme and imagery was too good to miss!

Of course, the key to a positive outcome in the current environment is not just reliant on the aforementioned fluffy tailed hopper and 19th century head gear. Before the magicians in finance (that’s us) can conjure the trick, ducks must be assembled and put in a row. Like most magic tricks’ preparation is key and best done in private so as to impress the audience.

While it’s not possible to write a definitive finance application preparation list in this format let’s have a look at a few key areas that will help us to help you.

Finance Application

Yes, it’s a laborious task and a spectacular example of the nanny state we live in. Resistance is useless and raging against the process is a waste of energy. Don’t paint yourself as “difficult” lest the bank decide that you’re more trouble than you’re worth. Stay calm and carry on filling in the many many forms.

Timeliness

We will describe you to the banks as a highly organised professional with exemplary management and record keeping skills. Try to help us prove it by being just that. Our staff are here to help. If you suck at collating bits of paper tell us and you will get all the support you need. We want to turn up at the bank with everything they need and no hint of the amount of paddling those ducks are doing below the surface.

Financial Records and the Tax Man

Lodge your tax on time, have your last few returns ready and make sure you have no overdue tax payments. If you have, tell us and let’s get this sorted before we turn up at the bank. If you have the money to clear the arrears do so. If not, we are going to need one hell of a story and preferably a true one.

Skeletons in the Closet

Got an ex-partner with asset claims. Maybe contested credit arrears and a loan guarantee on a relative who’s done a runner. We need to know, and we need the back story. Here’s a simple truth. Painful as it may be to disclose this sort of stuff it will speak volumes as to your character. Make no mistake, nothing looks worse than the bank finding out that you failed to make appropriate disclosures.

Risk and SWOT

Our job is to paint a picture. That picture should reflect a low risk transaction for a low risk borrower. There is no such thing as zero risk (buying the MD a bottle of Krug gets close) so the trick here is to identify risks and mitigate them. A compelling business plan (we can help), a few embarrassingly positive references (not from your mum), a detailed CV including your Nobel Prize in Economics and a SWOT analysis goes a long way. What’s SWOT you ask? No, it’s not a paramilitary credit approval persuasion team, as inviting a prospect as that may be. It’s a way of addressing key areas of your application via Strengths, Weaknesses, Opportunities and Threats.

The headings are self-explanatory but given that accommodation and property management have their own unique characteristics we are happy to review your plan and edit as necessary. Like the business plan, SWOT analysis should not get bogged down in waffle. For example, growing the letting pool as an opportunity only works if you can describe how you’re going to do it.

Demonstrating self-awareness is a big positive with lenders. Admitting a weakness and outlining the plan to get up to speed reflects strong business planning skills and will be well received. Trust me, the credit manager looking at your application can see where the weaknesses are so addressing them early just makes good sense. We will always discuss the pros and cons of your situation and work with you to develop a plan that maximises the chance of a good outcome. On the other hand, if you are clearly trying to climb Everest without oxygen or a rope we’ll suggest a stop at base camp. Not saying the summit is out of reach, just might be better to start with Mount Tamborine and work up from there.

Equity and Debt Servicing

You’ll need some equity by way of cash, sale of assets or supporting security such as a house you may own. If you are getting the dough from a third party, we need to know. If it turns out that money you said was yours turns out to be a “gift” your bank application will likely turn into a large paper plane heading our way at speed and on fire. A genuine gift from family is fine provided we know about it from the get-go and it’s documented accordingly. Equally, borrowing against your house is fine while borrowing against your 90-year-old mums, not so much. As always we need to know exactly what’s going on as we get one chance to present a compelling case to the bank.

Much has been written about debt service standards post banking royal commission. Having said that not much has really changed and that’s because the fundamentals remain true. We’ve got to be able to show a bank that you can meet your commitments from day to day cash flow, regardless of your gearing and asset position. If your loan term is 20 years and you take 5 years interest only you’ve got to be able to show that you can meet payments to clear the debt in 15 years, the so-called balance term. On top of this we’ve got to stress test your repayment capacity by using a higher interest rate than currently available. Arguments around the likelihood of interest rate rises, capacity to clear debt from asset sales etc don’t usually cut it.

Following the royal commission living expense tests, which can have a significant impact on debt service capacity outcomes, have moved to a more individual level rather than a standard allowance as was previously the case. This has led to borrowers being compelled to detail living costs in great detail and lenders to trawl through bank statements in some bizarre attempt to establish the lifestyle costs of the punter. The premise being that borrowers have no capacity to adjust their lifestyles in order to meet their commitments. This whole laughable saga came to a head when ASIC had a crack at Westpac in respect of their responsible lending living expense testing. I will leave you with what Justice Nye Perram had to say in his landmark, and entirely sensible, skewering of the ASIC case :

“I may eat wagyu beef every day washed down with the finest shiraz but, if I really want my new home, I can make do on much more modest fare,” wrote Justice Perram as he carved up the argument that a consumer’s declared living expenses should be the key to assessing whether they could meet loan obligations.

“The fact that the consumer spends $100 per month on caviar throws no light on whether a given loan will put the consumer into circumstances of substantial hardship.”

A blow for common sense to be sure.

Mike Phipps
Director | Phippsfin PL

After last month’s bulletin (some said rant but no offence) regarding bank lending and personal responsibility we received quite a lot of feedback. Most was based around misconceptions of how lender security works with suggestions that we need to drill down and provide some detail. Given that books have been written on this subject any brief summary will, of necessity, only skim the surface.

I should also point out that I am going to talk about a variety of security arrangements in very general terms and borrowers should always seek independent advice to ensure they fully understand their obligations.
So, without further ado, here goes!

Mortgages

The one bank security we are all familiar with. The borrower offers a piece of real estate they own or are buying as security for a loan. Default on the loan and the lender can sell the property to recover the money owed.

Charges Over Specific Assets

A charge over an asset is really just a mortgage over a specific item of value other than real estate. In fact, some lenders refer to taking security over a leasehold motel as a mortgage over the lease. Again, this instrument allows a lender to sell the charged asset to recover a default loan.

Company Charges

Back in the day these were broadly referred to as Fixed and Floating Charges (FFC). The object of the exercise was to take a security over a company’s balance sheet. Given that assets such as cash and debtors are very fluid while machinery and equipment is less so this instrument was designed to capture a range of business assets. More recently with the implementation of the Personal Property Security Act (PPSA) the FFC has been replaced with a similar arrangement called a General Security Agreement (GSA). The description of this arrangement is best summarised as a security interest over a company’s present and future acquired assets.

Guarantees

As the name suggests the guarantee is taken by a lender from a person or entity that is not the borrower. Lenders do this for numerous reasons. The most common is where the borrower is an incorporated entity and the guarantee is being sought from the people who either control that entity or benefit from its operations. As such a lender would ask for the personal guarantees of the directors, shareholders and any adult beneficiary of any trust for which the incorporated entity acted as trustee.

It is also quite common for lenders to ask for guarantees from entities on who’s income there is reliance for debt servicing. If the borrower has multiple business interests across various incorporated entities then those entities may well be asked for their guarantees. Ultimately the lender is looking at who controls cash flow and hence debt service capacity.

It is important to note that most personal guarantees where more than one guarantor is involved are documented as being joint and several. This means that all guarantors are guaranteeing the full amount of the debt and the lender can go after any guarantor for the full amount regardless of the actual share that person may have in the business. Essentially the joint promise by the guarantors creates a single obligation upon all of them.

In some instances, guarantees can be limited to the individuals share of the total debt. This is most often seen in partnerships where different investors have a variety of equity percentages.

Third Party Security and Cross Collateralisation

This is a very common situation in management rights transactions where a couple are the purchasers. Typically, the unit is purchased in a single personal name with the business acquired by a company with a sole director being the other partner. It is usual for the company to be acting as trustee for a discretionary trust with the couple as primary beneficiaries. The lenders will take a mortgage over the unit, a charge of the management and letting agreements, a GSA over the company and personal guarantees from both individuals. All security is cross collateralised so in effect all security serves to secure all debt.

In this instance, the two primary assets (unit and rights) are linked and cannot be dealt with individually. Also, there is clear commercial benefit for the individuals in terms of the security they are providing. That’s important because without demonstrated commercial benefit a lender will generally not take a security from a third party. This is particularly the case where a borrower is seeking to use a relative’s house as supporting security. Unless that relative is receiving a commercial benefit and has a level of ownership and control over the business the lender will not accept the security.

Of course, if the ultimate owner of an asset is essentially the same party taking out a loan all is well. A director of a company can offer an asset they own in their personal names as security for that company’s debt, that’s fine.

BTW – Don’t even think about parachuting your 90 year old parents into your company as directors and then using their home as security. No one, least of all the banks and your finance broker, want to be on 60 Minutes as your elderly folks are tipped out on the street after your business goes bust!

Asset Protection

When purchasing or starting a business, it’s always a good idea to consider strategies around protecting your assets from future legal action. This may take the form of acquiring the business in an incorporated entity unrelated to the ownership of personal assets such as the family home and ensuring the owner of the home and the director of the company are different people. It is important to understand that asset protection strategies do not extend to lenders in terms of security arrangements. If the lender has your unlimited guarantee then either directly or indirectly you are putting your personal assets on the line.

The management rights purchase structure I have described above is a good example of asset protection in terms of the managers unit being owned by an entity other than the business owner. Should a guest sustain an injury and sue the resident manager the unit is owned by a separate entity and thus would usually be out of scope in terms of any legal action.

Deeds of Consent and Rights of Entry

This security is seen most often in leasehold motel transactions and management rights transactions outside Queensland. The document is essentially a tripartite agreement between a landlord or owners corporation (OC), the owner of the business and the lender. If the motel freehold is mortgaged the landlord’s bank also gets involved.

The effect of this arrangement is to compel the landlord or OC to notify the lender of any defaults under the lease or agreements, allow the lender to move to remedy the default and if necessary step in and operate the business.

In Queensland the BCCMA includes lenders rights and responsibilities so no Deed of Consent and ROE are required albeit a financiers interest notification is provided to the Body Corporate by the lender.

Limited Recourse Lending

Essentially an arrangement where the borrower does not offer security which would allow a lender to pursue a range of otherwise standard debt recovery remedies. Typically, this will be no personal guarantees or cross collateralised security with the lender simply taking a mortgage or charge over the asset being financed. Limited recourse is not popular with lenders for obvious reasons and can sometimes suggest that the borrower is not confident in their capacity to meet their obligations.

However, on occasions there are commercially viable reasons for such a security structure and lenders will consider such requests on their merits. Lower loan to valuation ratios and higher interest rates will apply.

Summary

Each of these security arrangements could fill several volumes so please take this very much as a high-level overview. Read your specific loan documents carefully, understand your obligations and seek independent legal advice.

Most importantly, if you mortgage a property, offer a business as security or provide your guarantee understand that your worst case scenario is loss of the specific assets you have pledged and more broadly the loss of other assets in which you have an interest. It’s really that simple.

Mike Phipps F Fin
Director | Phippsfin Pty Ltd

I read with some amusement that our friends in government have realised that all the disclosure and “lets treat people like idiots” regulations that we now “enjoy” may in fact be very confusing to the average borrower. Lenders are now being told to explain things in simple English and in a manner that is clear, concise and easily understood. Let’s call it a conversational style of communication like the bulletins we have been publishing for years. Given that it’s not unusual for a borrower to receive, inclusive of the Product Disclosure Statements, upwards of 500 pages of information from a bank this seems like a step in the right direction. Of course, the challenge for lenders will be to communicate plainly, clearly and concisely while covering their bottoms from potential legal action. Sadly, some borrowers don’t understand the concept of personal responsibility. When you are filling out the mind-numbing paperwork involved in the simplest of borrowing applications feel free to face the general direction of the inner city latte sippers and thank them for their advocacy and commitment to your “protection”.

As it turns out we have always strived to ensure that our clients know what they are getting themselves into. In fact, I think we spend more time on education and financial counselling than actual finance broking. Given the regulator’s call to make things clearer I thought it might be helpful to summarise the key points for consideration when you borrow money. I won’t talk much about why you borrow money and what constitutes good and bad debt although I’ll make the following observations. Negative gearing, is, of itself, a flawed strategy. No sane person sets out to spend $1 to save 30 cents if that’s the end game! Borrowing for a depreciating asset likewise, unless you can claim a tax deduction, make money directly from the asset during its serviceable life or put the capital to better use. Spending tomorrows pay packet on consumer items via our many friends in the buy now, pay later game is a road to financial disaster and one step away from the pawn shop.

Anyway, let’s move on. While far from a definitive list here’s a bit of food for thought when borrowing money:

Why and at What Cost

Yes, always a good place to start. Why am I borrowing? We encourage borrowers to look at the use of debt from a whole cost perspective. That is, the cost of the asset being acquired, the purchase costs and the total interest costs over the proposed loan term. It always surprises me how few borrowers actually know what the likely total cost of borrowing for an asset is likely to be before they talk to us. Of course, there’s more to the decision than simple maths. For example, security of tenure in your own home or business is a very powerful driver behind the vast majority of borrowing decisions in this country.

Loan Structure and Security

We’ve written before about lending structure and security. As always, we strongly recommend reviewing that information as part of any borrowing decision. You should always consult your accountant and lawyer as part of that process.

A word on asset protection. Your lender will want full recourse to the security you offer and to any borrower or guarantor. An asset holding structure designed to protect those assets in the event of legal action or insolvency will not generally protect you from a full recourse secured lender. Consult your lawyer if ever in doubt.

Principal and Interest v Interest Only

One of the first decisions borrowers need to make is the Principal and Interest versus Interest Only conundrum. This decision comes back to the Why question. If interest only is appealing, we encourage borrowers to know why. Remember, going interest only just to keep your monthly payment lower is, of itself, a flawed approach. There are good reasons to apply for interest only finance which we’ve previously written about. However, all things considered, for many borrowers amortising debt, and fast, makes very good sense. One strategy that seems to work well for our clients is variable rate interest only finance with a strategy of paying down debt and building an offset or redraw facility. In most cases this is a strategy tied to a variable rate loan which allows the borrower to essentially pay down debt, reduce interest costs and build a buffer for the management of any future unforeseen cash flow issues. The strategy also allows borrowers to have access to liquidity for immediate investment without the need to apply to the bank.

An important consideration for business borrowers is the loan term. Some lenders will approve a 15 year loan with, say, 3 years interest only. Others will simply approve a 3 year interest only loan. It is critical to understand that the 3 year loan term is just that, 3 years, after which all bets are off. Your facility expires and you need to re-apply for any extension. Obviously short loan terms carry refinance risk albeit the interest rate is usually lower to reflect the bank’s shorter lending commitment.

In some rare instances term finance will be approved with what’s known as a balloon end payment. Essentially the lender calculates repayments to ensure partial pay down of the debt with a lump sum (balloon) payment required at a future point to clear the debt. Such arrangements need to be approached with a greater degree of analysis than other forms of loan structuring. The obvious risk with this type of finance is that the borrower arrives at the balloon date, doesn’t have the money to clear the debt and can’t refinance the balance.

Costs, Working Capital and Contingencies

We encourage borrowers to undertake a detailed budget before committing to a transaction. It is not wise to enter into any debt obligation before understanding all the costs involved and where your liquidity position will be post settlement. This is particularly true of business borrowers where cash flow cycles and contingencies need to be understood to ensure no financial stress. As always, we recommend borrowers review their budget and consult their accountant. Remember, contingency and fall-back capital is there for the things we don’t expect like, I dunno, a pandemic maybe!

In our view it’s not a great idea to borrow money where every last cent goes into your equity and costs with no margin for error.

Debt Servicing and Personal Budgets

Perhaps the most topical post banking royal commission issue. Lenders do a number of things behind the scenes which all borrowers should consider. The first is that they stress test your ability to meet your commitments. That means that when we talk to you about your finance, we are applying those stress tests. These tests are simply a means of applying some “what if” scenarios to our analysis and observing the results. Firstly, we apply a higher interest rate to your debt service capacity. Typically, this means adding 2 to 3 percent to current rates and seeing if you can survive such a rate rise. Then we take the total loan term, deduct any interest only period, and see if you can meet your repayments over the balance term, at the higher rate. Lenders also discount many forms of income to reflect any volatility risk. For example, rental income is discounted to reflect vacancy risk while share dividend income is discounted to reflect any volatility in public company profitability.

Lenders treat all debt facilities as if they were fully drawn. In practical terms that means that even if you owe nothing on your credit cards, we must assess them as if fully drawn and on a monthly repayment. Same goes for advance payments on your loan accounts.

Borrowers are required to complete a personal budget reflecting living expenses and this budget, together with current and proposed debt service commitments, is used to arrive at debt service capacity.

If we think you are not likely to be able to meet your commitments or that your plans may place you under financial stress, we have an obligation to tell you so. This duty of care extends to declining to assist a borrower who insists on proceeding in the face of a clearly unacceptable debt service risk.

Variable v Fixed Rates

We encourage borrowers to consider all options. Of course, there are pros and cons to both rate types. Variable rate loans generally have no early payment penalties and allow borrowers to make additional repayments as they see fit. For borrowers who plan to pay down debt faster than their contracted repayment we think variable rate loans make good sense. Of course, the downside is that rates may rise and the variable rate borrower may be exposed. You could move from variable to fixed of course but often times the rate horse has bolted by the time the danger is apparent.

Fixed rates provide certainty and for many borrowers are simply a means to sleep better knowing their repayments are locked in for the term of the fixed rate. Beware, penalties often apply when paying down or paying out a fixed rate facility during the fixed term.

An option for borrowers is to split their facilities and take an each way bet with a part fixed, part variable structure. Look out for duplicated loan account fees when assessing this option!

Refinancing

It’s important to note that some debt refinance transactions will attract exit fees and / or fixed interest rate and loan term break costs. If you are refinancing existing debt, you should seek a refinance payout quote from your existing mortgagee and consider if any increase in funding to cover refinance costs is required.

Changes in Circumstances

In these politically correct times, any discussion around changing circumstances must be treated with great caution. On the one hand common sense suggests that if a borrower is planning a material change in their lives that’s worthy of some consideration. On the other hand, any discrimination on the basis of lifestyle choices could place a lender in very warm water indeed.

We encourage all borrowers to consider any anticipated change in their circumstances in terms of impact on income. Budget accordingly and if your future plans suggest financial jeopardy let’s have that discussion.

Education

If there’s one thing we would encourage borrowers to do above all else it’s to understand concepts around money, budgeting and debt. Start with two simple spreadsheets. Have your assets and liabilities on one and your month-to-month budget and bills on the other. Have the discipline to keep both up to date. You’ll be amazed how much better you’ll sleep.

Remember, we are here to help, even if that means No.

Mike Phipps F Fin
Director | Phippsfin Pty Ltd