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Understanding low equity margin (LEM) and low deposit home loans

Low equity margin (LEM), aka low equity premium (LEP), is the price you pay for having a smaller-than-optimum deposit for the property you want to buy. It’s either an extra bit of interest that’s added to the going rates or a one-off fee that’s added to your loan.

As house prices creep up, it’s getting harder to gather together the preferred 20% (or more) equity deposit, so you might find yourself in the position of looking for a low deposit home loan. If it’s your first home your deposit could, in theory, be as small as 5%. However, it’s always important to remember that the smaller the deposit, the larger the LEM and the larger the monthly repayments.

What does low equity margin mean?

A low equity margin (LEM) or low equity premium (LEP) is the extra expense you have to pay because your deposit is less than 20% of the property purchase price. Some lenders charge it as an annual extra interest charge. Others, like ANZ, charge it as a one-off fee at the start of your loan.

When you’re talking to a lender about LEM, you’ll quickly come across another acronym – LVR. This stands for ‘loan to value ratio’ and it refers to the amount you need to borrow as a percentage of the total value of the property. When the LVR is greater than 80%, you can expect to pay a LEM.

Here’s an example to explain LEM as an extra interest charge:

  • You’re buying a property worth $900,000
  • Your deposit is $108,000, 12% of the purchase price, so your LVR (loan to value ratio) is 88%
  • You are borrowing $792,000 at 4% interest fixed for three years
  • Because your deposit is only 12%, the lender adds 0.75% to your rate
  • All up, you pay 4.75% interest per annum

Here’s an example to explain LEM as a one-off fee:

  • You’re buying a property worth $900,000
  • Your deposit is $108,000, 12% of the purchase price, so your LVR (loan to value ratio) is 88%
  • You are borrowing $792,000 at 4% interest fixed for three years
  • Because your deposit is only 12%, the lender charges you a one-off fee of 0.75% – $5940
  • The fee can either be paid on settlement day or added to your loan total

Why do banks and other lenders charge a LEM?

A low equity margin is charged by lenders to offset the additional risk they take on when they lend to someone with a smaller-than-optimum deposit. The lender perceives a higher risk of a customer defaulting (not being able to make payments) when they have a minimal deposit. And that makes sense when you consider that a smaller deposit means bigger repayments, which can make household budgeting a challenge.

How can you reduce your low equity margin?

If a lender has indicated that you’ll be charged a LEM when you borrow, and you haven’t signed up yet, there are a few strategies to consider:

  • If it’s your first home, thoroughly investigate the possibilities of KiwiSaver and Kainga Ora financial input. More about those further down.
  • Increase your deposit by selling some assets (vintage guitar collection, original artworks, jewellery…whatever you’ve accumulated that’s valuable and potentially easy to liquidate).
  • Downgrade your vehicle to something less expensive and cheap to run. The equity you release can go towards your home deposit.
  • If you and your partner have two cars, think about how you could change down to just one.
  • Ask a family member for a loan. A cash injection could bump up your deposit, so that you don’t have to pay a LEM. If you go this way, be sure to tie things down with legal documentation that details the amount and repayment terms, to avoid family squabbles in the future. When you put a family loan towards a home deposit, your lender will require a Deed of Acknowledgment that confirms the loan won’t have to be repaid until the property is sold.
  • Family members can also gift you money. This sometimes happens when parents who have plenty of equity want to help their children buy a property. Your lender will want confirmation that the money doesn’t have to be repaid, so you’ll probably need a lawyer to draw up an agreement.
  • Put property buying on the back burner until you’ve accumulated a bigger deposit. Go on a savings binge or find an extra source of income to get your deposit growing as fast as possible.

How does low deposit lending work?

Low deposit lending works much the same as optimum deposit lending. You find a lender you like and apply for a loan. The difference occurs just after they see the size of your deposit. That’s when they’ll pay extra-close attention to every aspect of your application, including your household budgeting and savings history. If everything looks solid, you may be offered a loan, but with a LEM attached.

The size of the LEM depends on your LVR (loan to value ratio). Here’s a typical schedule for LEMs that are charged as an extra chunk of annual interest: 1, 2

  • LVR between 80.01% to 85% LVR – LEM of 0.35% p.a.
  • LVR between 85.01% to 90% – LEM of 0.75% p.a.
  • LVR between 90.01% to 95% – LEM of 1.00% p.a.
  • LVR over 95.01% – LEM of 1.15% p.a.

And here’s a typical schedule for LEMs that are charged as a one-off low equity premium fee: 1, 3

  • LVR between 80.01 to 85.00% – 0.25% of loan amount
  • LVR between 85.01 to 90.00% loan to value ratio – 0.75% of loan amount
  • LVR between over 90.01% t0 – 2.00% of loan amount

Even if you’re willing to pay the LEM, Reserve Bank restrictions mean that only 20% of a bank’s new lending for owner-occupied residential housing can have an LVR of more than 80%. So, whether your bank can offer you a low deposit loan sometimes hinges on whether they have any of their permitted 20% capacity left.

How do you apply for a low deposit home loan?

Start by drawing up a short list of lenders that offer low deposit home loans. Look beyond the big banks, because there are plenty of non-bank lenders (private equity financiers) operating in the low deposit home loan space.

A key difference between banks and non-bank financial institutions is that non-banks don’t hold a New Zealand banking licence. Also, they’re privately owned (not publically-listed) and aren’t governed by the Financial Markets Authority. However, it’s reassuring to know that they are regulated by the Reserve Bank.

How can KiwiSaver help with low deposit home loans?

If you save with KiwiSaver for three years or more, you can withdraw nearly all your contributions towards a first home deposit ($1,000 needs to remain in your KiwiSaver account). Inland Revenue has a helpful page about this.

Can you access the Kāinga Ora benefits for first home buyers?

Kāinga Ora – Homes and Communities was formed in 2019. It brings together KiwiBuild, Housing New Zealand and its subsidiary HLC. Part of Kāinga Ora’s role is to assist first home ownership in New Zealand. They do this through the First Home Grant and First Home Loan initiatives.

  • A Kāinga Ora First Home Grant of up to $10,000 could be available to you if you’ve been a member of KiwiSaver for at least three years. You need to meet other criteria too.
  • A First Home Loan is issued by a selected lender and underwritten by Kāinga Ora. You only need a 5% deposit, however the lender is likely to apply a LEM.

If you want to pursue assistance from Kāinga Ora to buy a first home, visit their website.

Can you get your low equity margin removed if the property increases in value?

If you go with a lender who adds an extra dollop of interest as their LEM, there’s a very good chance you won’t have to keep paying this extra interest year after year. Two things are going on that will assist your position. One, you’re making repayments that are gradually repaying some of the loan’s principal. Two, your home is quite probably increasing in value.

After a year or so, you can think about getting that pesky LEM removed from your loan. Here’s the process for getting it gone:

  • Prove to the bank that the amount left on your home loan is less than 80% of the value of your property.
  • Check out your home’s estimated value on a site like homes.co.nz, or oneroof.co.nz. or you can pay for a digital valuation from companies like Valocity and CoreLogic. These will give you a ballpark indication of your property’s current worth. Alternatively, you can get a ‘registered valuation’ from a reputable valuation company in your area , it is worth checking with your lender if they are a ‘lender approved valuation company’. A registered valuation comprises a site visit by an approved valuer and a subsequent valuation report, which will state a market valuation of the property. Expect to pay between $850-$1000 depending on the type of dwelling.
  • Look at how much you still owe and the property’s estimated value, then do the LVR calculation (divide the amount of the loan by the value of the property).
  • If the numbers look good (LVR of 80% or less), the next step is a registered valuation. The bank will choose the valuer, to ensure there’s no room for bias. You’ll have to pay the cost of the valuation.
  • When your lender agrees that you fit the 80% or less LVR rules, they will remove your low equity margin.

Can you make a lump sum payment into your mortgage to improve your LVR?

If your loan is on a floating interest rate, you can make extra payments any time you like. Along with your regular repayments, every extra payment will improve your LVR. Eventually you can have the LEM removed.

If your home loan is on a fixed rate, you might be charged a penalty fee for making extra payments. Always check with your lender first, because the penalty might mean it’s not worthwhile. When your home loan comes off fixed and goes onto floating, you can make an extra payment without penalty.

A LEM isn’t forever, so don’t be put off

Now that you know more about low deposit home loans and low equity margins, you can approach the task of buying a home with your eyes wide open. It’s quite possible that moving quickly and paying a LEM will be preferable to waiting, because the property market never sleeps.

To learn more:

Read more about deposits for first homes.

Sources
1: As at 24/09/2021
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