Security substitution keeps a good loan open | Real example

What is security substitution?

Security substitution is when a borrower removes an existing property that supports a home loan and replaces it with something similar—either property or sometimes cash.

Security substitution is used interchangeably with home loan portability. Security swap is another term you might hear lenders use.

I explored the concept of changing property and home loans without a new home loan application in my article on home loan portability.

In this article I explain how security substitution can be used to prevent a useful home loan from closing.

Say what?

Yes. Some home loans are worth keeping….

What is a good home loan?

A better question to ask is what makes a good home loan to you?

Maybe it is the loan you have – the one that got you into the market.

Maybe it is the rate you are on – one you would not get again if you applied today.

Sometimes it is a home loan that allows you to be nimble in market where getting another home loan is difficult or time sensitive.

Maybe it is a home loan you have not used yet – but plan to in the future.

The good loan I talk about in this example is a very handy investment loan. I share a borrower story about how ‘keeping an investment loan’, using security substitution, put borrowers in a stronger financial position.

What makes an investment home loan good?

If I had to choose between a home loan where interest costs are tax deductible or not—I choose tax deductible. I will let the ATO explains the difference here.

Over my time mortgage broking, I helped establish hundreds of home loans enabling clients to deduct interest costs from their taxable income—commonly to buy investment property.

The ABS reported that in 2019-2020 over two million households owned a property other than the one they lived in. This scenario deals with one of those families.

How investment loans often start

Many Australian homeowners use equity they might have in their current home to assist with borrowing for an investment property purchase.

Importantly, the property a home loan is used for do not always align. I write about using equity to buy an investment property here.

Borrowers can end up with two loans when they buy one investment property. They can both be tax deductible. Sometimes at different lenders too.

The mistake some borrowers make

When a property is sold, unless borrowers are proactive, the default practice is for a lender to close the loans that property is supporting.

An all too common mistake is when a borrower unknowingly closes a loan they did not release was a very useful investment loan.

I explain how this mistake was avoided in an example below.

REAL EXAMPLE*
Why this borrower kept their home loan open

In a nutshell – To preserve investment debt.

In this borrower’s case, they needed to sell a property to achieve an upgrade to a family home.

Here is a situation a client of mine found themselves in.

Goal – Buy the ‘family home’.

Here is how their loans and securities were structured:

Property 1
Two loans used Property 1 as security.

$210,000 – A home loan directly related to the Property 1 being sold
$90,000 – Investment home loan that drew on existing equity to buy Property 2

Property 2
Property 2 secures one loan of $310,000.

IMPORTANT: I was advised investment loans used for Property 2 are both the $90,000 and $310,000. So, $400,000 investment lending in total.

THE PLAN
Client wanted to be fully prepared to buy a property when an opportunity presented. They sold Property 1 to release equity in preparation.

THE MISTAKE they avoided:
Selling Property 1 and paying down the loans ($210,000 and $90,000) would leave $100,000 leftover to put towards a new family home.

Buying a new home for $800,000 would leave borrowers with home loan debt of $700,000.

This works. Borrowers get their property. But the finance structure is not ideal compared to the solution below.

THE SOLUTION
STAGE 1 – SECURITY SUBSTITUTION
Sell Property 1. Instead of paying out all loans, clients did this:

Close $210,000 loan – Not needed anymore. That loan was for Property 1.
Keep $90,000 loan – This was an investment loan still able to be utilised for Property 2.

What to do with the $90,000 loan?
A first check is to see if there is enough equity in Property 2. It makes sense as that is what the loan was for:
$310,000 – Existing Property 2 loan
$360,000 – Existing Property 2 value

Adding the $90,000 loan to this it would put borrower in a position where they owe more than the property is worth—negative equity.

Instead, borrowers kept the $90,000 loan by using a security substitution lender feature.

Borrowers requested the lender keep the $90,000 home loan open and instead of property, use some of the sale proceeds ($90,000) as a replacement security.

At the same time the property was sold this happened:

• $210,000 loan was paid out and closed
• $90,000 loan was kept open by securing it against $90,000 in a term deposit account at the same lender.
• In addition to the funds in term deposit, borrowers still had $100,000 in cash left over from sale.

That is a security substitution – The borrower substituted the security that supported the $90,000 loan:

PROPERTY OUT – CASH IN

The borrower then had time to find a property to buy.

STAGE 2 – ALIGN INVESTMENT LOAN TO NEW PROPERTY
Once a property was found the borrower applied for new lending and replaced the cash security supporting the $90,000 with the new property.

This is the result – and the borrower benefit:

By moving a $90,000 investment loan to the new property it left $190,000 ($100,000 cash plus $90,000 from term deposit) available to reduce the required owner-occupied loan amount.

Total debt same as before except the owner-occupied home loan is $610,000 instead of $700,000— voilà.

Both scenarios were going to end in $1,010,000 of total debt. See here:

Same overall loan amount – why is it better?

This client was taking on owner occupied debt.

Loans for investment purposes are treated differently for tax purposes than loans for owner-occupied purposes.

These borrowers were advised by their accountant to preserve their investment lending for Property 2 as these costs were tax deductible – owner occupied loan costs were not.

Both scenarios had $1,010,000 in debt.

No security substitution – 30% investment debt

With security substitution – 39% investment debt

A popular goal for home owners is to be mortgage free on their principal home.

A $610,000 home loan compared to a $700,000 home loans got these clients $90,000 closer to that goal from day one.

Other examples of security substitution

Over my years as a mortgage broker, I have assisted in several security substitution transactions. Here are a few more examples.

Guarantor wants to sell property

Guarantor wanted to sell investment property to cash in on equity and produce income with sales proceeds.

Problem: Guarantors property was supporting kids home loan.

Solution: As kids did not demonstrate enough equity to remove the guarantee, the lender approved a security substitution.

What happened?
Guarantor sold the investment property. Some of the sales proceeds went to open a cash account in guarantors name to act as the replacement security for the home loan guarantee.

Guarantor earned interest from a term deposit.

Kids continued with the home loan and were not forced to sell.

Guarantor wants to move sell own home

Guarantor using owner occupied home to support kids home loan.

Problem: Guarantor wanted to sell and move house but this property was securing part of the kids home loan.

Solution: Security substitution without a full home loan application.

What happened?
Lender approved a security substitution for guarantors new home to be used as security guarantee for kids home loan. This meant guarantors could sell and move home while kids continued with home loan.

Selling then buying in another state

Borrowers wanted to buy a new property in ACT and sell in WA. Borrowers were happy with their home loan.

Problem: Borrowers did not want to apply for a new home loan.

Solution: Security substitution allowed for borrowers to keep home loan and changed the property securing it from WA and ACT.

Is security substitution worth it?

Mortgage brokers act in client’s best interests and need to demonstrate a security substitution is worth it.

It takes a professional to assess whether a security substitution fits with your future goals and objectives.

Even if it sounds like a good idea, a security substitution is not always possible. The earlier borrowers engage a mortgage broker, the better prepared they can be.

Generally, fees for the specific security substitution request are nominal – $300 to $500 as a guide.

An important point is that security substitution keeps the home loan active. This means there will probably be repayments, interest costs and loan fees to continue to pay.

A substitution, if an available option, needs to be put next to all lending possibilities. Whether it is worth it should be clear to see once options are laid out in front of you.

Considerations for security substitution

Never assume anything when it comes to security substitution. There can be many variables and lender conditions to meet. It is something I recommend you use a mortgage broker to assess suitability.

I explain some of the eligibility criteria in my article on home loan portability.

Final word

Security substitution and interest rates are both features of a home loan. One has headline pulling power and the other does not.

But used correctly, security substitution transactions can put borrowers in a much stronger financial position than a tunnel visioned focus on interest rates is likely to deliver.

Good mortgage brokers take the time to properly understand client future goals and objectives. This example showed how, in combination with clients’ own tax advice, and a lender with a security substitution feature, delivered a great loan solution.

*Calculations are used to illustrate examples we have used in this article. They are based on a real example but figures differ. No accounting for costs like LMI or transaction costs. They are designed to educate and empower the reader by complimenting the contents of the article.
The graphs and interest rates are for illustrative purposes only and do not take into account the individual’s needs and requirements.
For a personalised discussion, please contact your mortgage broker and / or financial adviser.