In our work with borrowers we come across a lot of ‘urban myths’ about borrowing – things which drive people’s behaviour which are fundamentally misinformed. So as the first in a series which I’ll put out in subsequent newsletters, here are some urban myths exposed.
Don’t mortgage your own home.
Perhaps the most frequent myth is the idea people have that if your own house isn’t mortgaged, it’s safe from any financial action. Wrong!
The law is that if you owe money to someone, they can come after you and sell any assets you own until they get their money. So if you have a house, it’s effectively on the line any time you enter a contract – for instance for dry cleaning or telephone services. Of course, most small debtors won’t go to the trouble of selling your home up – it’s not worth it to them for such a small debt.
Having said that, if you can keep your own house unencumbered that’s a nice thing to do, other things being equal. But given what I’ve said above, it’s throwing good money after bad if you need to bear additional costs to keep your own house free of a mortgage. People often have to pay mortgage insurance – no small amount of money – to keep their own house unencumbered.
Take the following example. The Smiths have an unmortgaged house worth $500,000 that they live in and want to purchase an investment property worth $300,000. They have $60,000 as a deposit for a house in Sydney. But buying the house without encumbering their own house will cost them more than $3,000 in mortgage insurance. But what if they can’t meet their bill? Say a terrorist act blows up their house, that the house cannot be insured against terrorist acts, that it’s now unrentable and they cannot meet their repayments. The lender can – and probably will – sell up not just their investment property. Since its value is well below what they owe, the lender can then – and probably will sell their home. Remember the law is that generally a debtor can sell your assets till your debt to them is fully repaid.
Now you could argue that not mortgaging the house could at least affect the order in which the assets were sold. Thus, not encumbering your own house improves the likelihood that your investment property would be sold first. As a legal observation, this is true enough. But it seems to me very likely that if the investment property would clearly yield enough money to repay the mortgage, a lender would happily allow you to sell that in place of your home: That is, it would let you behave as if your investment property was the one with the mortgage.
Why would it do so? Firstly because, provided that this can raise the money it needs, it’s no skin off the lender’s nose. Secondly there is in fact something in it for the lender. Lenders don’t like selling people’s homes because every now and again it ends them up on a TV current affairs program playing the role of evil villain. Part of the reason banks are conservative about people being able to service their loans (even when their loan to valuation ratio is very low) is that they hate those current affairs stories. Lenders hate throwing people out of their homes. Of course there is the chance that you run into a really unreasonable lender, but I’d be very loath to pay thousands of dollars of mortgage insurance to have so little effect on the final outcome.
In this example, in most cases the best approach would generally have been to mortgage the home and leave the investment property unencumbered – leaving it available for the raising of more finance if that was desired at some later time.
If you really do want to keep creditors’ hands off your family home then you need to consult an accountant and have the property title put in a different name to your own. Thus generally speaking (though there can be exceptions) a spouse owning a home can hold onto it even if her husband is bankrupted (and of course vice versa). And if you hold your own house in the name of a company or trust this may protect it also (though of course creditors may be able to access the asset through the company if you own shares in the company).
You shouldn’t do any of these things without getting the advice of a professional you trust. Another option is ‘non- recourse’ lending where the lender has recourse to the security backing the loan – they can sell the house that is mortgaged – but their rights end upon doing so. You can get access to this kind of lending, which is standard in the United States because of government regulation. But you shouldn’t be surprised to find that it costs more – because it’s higher risk for the lender.