Do You Know The Power Your Lender Has Over You?
Very few people read through mortgage contracts and understand what they are agreeing to. Most of these contracts have clauses that are very one sided and give the lender a lot of power over the borrower, particularly in cases of default.
Most people would agree that if a borrower fails to meet his or her repayment obligations then a default event has occurred. However, this is only the most common form of default.
The Dreaded Non-Monetary Default Clause
A “non-monetary default” can exist where all payment obligations have been met but the lender still has authority to take control of the asset.
Small business lending contracts most commonly contain these clauses. The lender can exercise this right when it decides that the risk associated with the business, its industry, its assets or its location has changed. This can be true even when all loan repayments have been made on time and in full.
For property investors, the most frequent cause of non-monetary defaults is where the loan to value ratio (LVR) of the debt is deemed to have increased to an unacceptable level after a revaluation. In such cases, the lender may require the borrower to contribute more cash to reduce the LVR or risk losing associated assets.
Non-monetary defaults have been in the news lately as representatives of farmers have raised concerns about unfair loan terms in a parliamentary inquiry.
Some Good News for Property Investors
As of this week, all four big banks, led by Commonwealth Bank, have bowed to public pressure and removed all non-monetary default clauses in contracts with small to medium size businesses. The changes have gone into effect for all loans under $3 million.
Loans for commercial property and residential development fall within the classification of small business loans. These changes by the big four banks will therefore positively impact many property investors.
The short duration of most property development loans largely cancels out the benefit of these changes. However, they still represent a shifting of risk from investors back to the banks.
These changes also highlight the power that lenders have over borrowers and the degree to which lenders seek to put as much risk as possible back on the borrower. This is the primary reason why banks love to cross-collateralise loans.
Beware the “All Monies” Clause
The “all monies” clause is the standard term in mortgage contracts that most increases the risk of property investors. Loan agreements are generally worded so that the property being mortgaged becomes security for all debts with that lender. This also includes further monies lent at any time in the future.
This clause has a two-fold impact on the lender’s power and the borrower’s risk:
- It gives the lender priority over other unsecured creditors and commonly over other lenders lodging a second or third mortgage over the asset.
- It gives the lender the right to hold as security for that asset any other asset it is holding as security on other loans. The two loans do not have to be cross collateralised to be captured by this clause.
How You Can Protect Yourself
If you have two loans with the same lender and you default on one of them, the lender can call in both loans and can access any other security currently held on other loans to cover either debt. This is a similar outcome as if two loans are cross secured.
While the level of control enjoyed by the lender is not to the same extent as with cross-collateralised loans, there is a connection that adds additional risk to you as the borrower. This does not necessarily mean that you should use a different lender for every single loan. Sometimes there are convenience and price benefits to using the same lender. Just be sure you weigh the benefits against the extra power you’re giving to the lender.
In general, the sensible choice is to have as much separation as possible between personal assets, such as the family home, and business or investing debt. Most of us have borrowed to purchase a home and very few people are able to start investing without accessing equity from the personal home. However, there is little stopping investors from using a second lender for further investment debt.
You should always consider the power your lender has over you when contemplating the most appropriate and beneficial loan structure for your investments. If you have any queries on this or any other finance-related topic, please leave an expression of interest with my team at PropertyInvestingFinance.com or email me directly.