28th November 2007
Investing in a mortgage scheme
“I wish to get a better rate of return on my money and don’t really mind having an indirect exposure to property as the underlying asset class.'
That's roughly how a mortgage scheme works, except it involves three extra features:
- More than one person contributes money to the scheme;
- Investors' money is pooled together or used in a common enterprise for scheme members; and
- Scheme members give up day to day control over how the scheme operates.
Like any investment, you face risks. Your returns will be affected by the ups and downs of property values and interest rates. You also rely on the skill and honesty of scheme managers and property valuers to find borrowers who can pay on time, with adequate security.
In the past, most mortgage schemes have operated successfully. Some regrettably got into disastrous financial trouble, because the managers lacked the skill to manage mortgages, especially when some of the borrowers failed to pay, or they lent too much money on optimistic valuations or risky development properties. A handful of operators defrauded investors.
Here we offer you some tips and safety checks that may help you decide whether to invest in a mortgage scheme.
Does a mortgage scheme investment suit you?
Mortgage schemes pay you an income from the interest the scheme receives from the borrowers. When the mortgage term expires, you are entitled to get back only the capital you put in. You will usually get a higher income compared with many other ways of lending or investing your money. However as it is a term investment you may find it harder to cash in your investment if you need your money before the mortgage expires, so if you need your money back at short notice, a mortgage scheme may not suit you.
What risks arise in mortgage schemes?
Your main risks in a mortgage scheme arise if the borrower:
- fails to make interest payments; or
- cannot pay back the loan amount at the end of the loan.
If the borrower fails to pay the interest then you may not receive any income. If the borrower cannot pay back the loan amount you will not get your capital back unless enough money can be raised from selling the property. If the valuation of the property is incorrect or property values have fallen, then you may not get all of your investment back. You will not get all of your investment back if the property is sold for less than the amount that the borrower has borrowed plus any costs incurred.
Watch your margin of safety
Before you invest, know the value of the land and how much of that value is being lent to the borrower (described as the loan-to-valuation ratio). The closer the amount lent to the value of the land, the higher the risk that you might lose part of your investment. A $60,000 loan for a property valued at $100,000 represents a conservative 60% loan-to-valuation ratio, but a $95,000 loan on the same property represents a much riskier 95% loan-to-valuation ratio.
What type of scheme can you choose?
Mortgage schemes can be set up in different ways. You can choose:
- Pooled mortgages where all investors share in all the mortgages. You therefore take your share in all the income and spread the risks across all the mortgages that the scheme manages. LOW RISK
- Contributory mortgages where you choose which mortgage(s) you invest in. Your mortgage(s) may pay a different income than other mortgages in the scheme. Your risk depends on the quality of the borrowers to whom you have chosen to lend. MEDIUM RISK
- Debenture or mortgage companies, where you invest in shares or debentures issued by a company that invests in mortgages. Here, you are really becoming a shareholder in or lender to the company, which in turn owns the mortgages. Check whether the mortgages are pooled or linked to specific properties. HIGH RISK.
La Trobe only operates the first two (2) types being a Pooled Option, and then a Contributory (“Select”) Option. We do not operate a debenture or promissory note scheme due to the lower security for investors.
What type of scheme managers can you choose?
All scheme operators must treat investors honestly. Generally large mortgage scheme operators face stricter controls than those operating small schemes.
At present you will find these types of scheme managers:
- Managers of registered schemes must operate the scheme through a public company that holds an Australian Financial Services Licence and comes under ASIC regulation. (You can check this licence for free through the ASIC website or contact the ASIC Infoline by email firstname.lastname@example.org or ring 1300 300 630.) The scheme must have a constitution, a compliance plan and a product disclosure statement that you can inspect. It must also have proper internal procedures for handling complaints, and be a member of an authorised external complaints scheme.
- Managers of industry supervised schemes must be supervised either by the Law Society of NSW or the Law Institute of Victoria. First, get a copy of the rules set by each body, then make sure any scheme you are considering is abiding by the rules before you invest.
- Directors of mortgage debenture companies must operate through a public company. They must act honestly and diligently, but require no licences or complaints schemes. The directors are free to choose whatever operating systems they like so long as they obey general company law.
- Managers of unregistered and unlicenced schemes must restrict their scheme to 20 people or less and must not be in the business of promoting schemes. Unregistered schemes are not regulated by anybody. You are on your own. Check everything and everybody involved.
What should you choose?
Mortgage schemes may suit your needs and circumstances. Choose the scheme and the manager that suits your own knowledge and experience. If you possess no expertise in property, valuation or checking potential borrowers, you will probably be safer with a registered investment scheme.
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Head of Funds Management
t +61 3 8610 2811
Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
Read full profile here.
La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.
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