If you have owned a home for a few years, there is a high chance that it has built up reasonable equity over time.
It can be a valuable resource to fund your household expenses, future property investment, or retirement.
This blog discusses what equity is, how you can use the equity in your home to buy an investment property, and much more.
1. What Does Equity In Your Home Mean?
Equity in an investment asset is defined as the asset's value minus any outstanding debt.
It is the difference between the assets current market value and the remaining loan or mortgage balance.
For instance, if your property is currently valued at $500,000, and you still owe $400,000 on your mortgage, your accessible equity in your home stands at $100,000.
2. How Does Equity Work?
Your equity is your untapped wealth. Equity works both ways, meaning it reduces if your property value falls and increases as the property’s value rises due to fluctuations in supply and demand.
Additionally, your equity also increases as you renovate your property or pay off your home loan by:
Making dedicated mortgage payments, i.e., interest and principal repayments
Making additional loan repayments
Opening an offset sub-account to reduce your loan balance
You can leverage your equity by borrowing a loan against it to fund the following:
Maintaining or extending your home to increase its appeal and value, using it for non-investment purposes like buying a car, new furniture, going on a holiday, etc.
Supplements your retirement using a reverse mortgage or home reversion.
One of the great things about using equity is that you can take advantage of a home equity loan by using it as collateral with the banks. This way, you can buy a second home or an investment property without a cash deposit or selling your existing home.
Here is How it Works:
You can access the built-up equity from your home or investment property minus its outstanding debt as a deposit to buy a second property. In this case, your current property becomes collateral on the new debt.
When you apply for a home equity loan, the lender will calculate your loan-to-value ratio (LVR) to verify that you have sufficient equity available for collateral. Lenders usually offer 80% of the property value as a home equity loan to fund your second property purchase.
For anything more than this, you will need Lenders Mortgage Insurance. Besides arranging funds for the property's market value, you will also need some money to pay for stamp duty and legal fees.
You need to decide how you wish to use your equity in your property. The available options include:
As a Deposit: You can use your usable equity in your property as a deposit against a home equity loan. With sufficient equity, you can borrow 80% of the property’s current market value without using your cash.
A Line of Credit: You will get a certain amount of credit based on your usable equity. You can structure it using a line of credit where you will only have to pay interest on the amount you spend. Combining it with an offset account will help lower the loan interest.
Cross Collateralisation: This option involves using the equity of your existing property as collateral for loans on both new and existing properties.
So, instead of using your equity as a deposit for a separate property mortgage with a different lender, your loans will get linked to the existing loan lender as your home equity is used as a security for both.
However, the risk in using this strategy is that the bank can repossess all properties under the loan if you fail to repay the loan.
3. Can You Use Equity As A Deposit On An Investment Property?
Yes. Here is how equity works when buying a second home.
The process involves using the available in-built equity in your home as collateral in place of a usual cash deposit.
Let us assume you wish to purchase an investment property with a market value of $400,000. Considering the extra property buying costs, such as stamp duty, legal fees, etc., of $20,000, the total property cost comes to $420,000.
If you fulfil the loan approval requisites, a lender funds 80% of the property’s market value - even more if you pay Lenders Mortgage Insurance (LMI). So, the bank will lend you a home equity loan of $320,000 to buy the investment property.
Some lenders even lend you up to 95% of the property value minus the current mortgage, provided that the borrower pays the LMI on the amount borrowed over 80%.
The total property price is $420,000, so you need a deposit worth $100,000 and other upfront expenses. You can get this amount from the usable equity in your current home.
Now, let's understand what usable equity is. Suppose the market value of your current home is $500,000, and the outstanding mortgage on your home is $300,000. In that case, the difference between the two is your usable equity, i.e., $200,000.
Total property price – $420,000
Bank home equity loan (80% property market value)– $320,000
Deposit - $ 100,000 (Usable equity -$160,000)
So, instead of paying a cash deposit for the down payment of $100,000 to buy the investment property, you can use your accessible equity of $160,000 in your existing home.
4. Pros And Cons Of Using Equity To Buy An Investment Property
Taking out a second mortgage implies you can access a large sum of money using your home as collateral.
Such loans offer you low interest rates and a tax benefit. You can use it to finance home enhancements, consolidate debt, and pay higher education costs.
However, there can be some substantial risks that you should pay attention to when considering a second mortgage. The critical risk is losing your home if you fail to make payments.
Second mortgages enable you to access the unused equity in your home for cash.
It helps build on your property investment portfolio
You can use home equity loans to pay for significant expenses like college fees or major renovations.
Closing on a second mortgage incurs charges in the form of closing costs, appraisal fees, etc.
You may only qualify for a second mortgage loan if your property price appreciates more and you have sufficient equity in your home.
5. How To Use Your Home Equity To Buy An Investment Property In Australia?
Step 1: Calculate The Usable Equity
Determine the equity amount available in your property using the simple formula:
Available equity = Estimated market price of your home - the balance of your current loans running on your home.
Step 2: Find Out the "Accessible" Equity
You may be unable to access the total available equity to achieve your plans. Your ability to service any extra repayments can impact the equity you can access.
Therefore, the next step is determining useable equity, or how much equity you can access and use to buy a second property.
A lending institution will only lend you 80% of a real estate’s market value against your home equity as a deposit for the loan. Now, deduct the amount due on your home loan from it. The remaining amount is your useable equity.
You can also find a usable equity calculator that lets you determine how much equity in your home you can access and use.
Your home’s market value – $800,000
Home equity loan amount - 80% of property value = 0.80*($800,000) = $640,000
Outstanding debt on your property - $500,000
Usable equity = Home equity loan amount - Outstanding debt on the property = $140,000.
Suppose your usable equity is inadequate to meet the entire deposit and associated fees (settlement costs and stamp duty charges). In that case, you must pay the rest in cash.
You can purchase an investment property with a deposit of less than 20% (or borrow over 80%) by taking out Lenders’ Mortgage Insurance.
However, you will have to pay 2-3% of the loan amount as an extra fee and higher interest rates on the investment loan.
Step 3: Get Property Valuation by Lender
When you engage with a lender or mortgage broker, they will conduct a property valuation to evaluate its current market worth. After this assessment, you can utilise this equity to secure a larger loan.
Your borrowing ability will depend on the loan-to-value ratio applicable to your loan. Most lenders limit LVR to 80%, which implies you can borrow up to 80% of the current property price.
Before approving a home equity loan, the lender will assess your income, general living expenses, debts, number of children, and other factors.
Step 4: Review Your Loan Options
Start researching and evaluating your home loan options with a Mortgage Choice broker at this stage.
Compare different loan options based on interest rates, features, and fees from your current lender or other lenders in the market to find the best one.
Step 5: Decide How To Access The Equity Loan
Make a proper plan to use your property equity so that it makes good investment sense. With the correct structuring of your investment loan as a separate loan against your home, the loan interest will become tax-deductible.
Choose from the following options to access your equity based on your individual circumstances. Some of these methods include:
Get your equity released as a one-off payment rather than paying fees for setting up and using a line of credit. A lump-sum equity release can be helpful if your investment plan validates the amount you will be dishing out on loan interest repayments.
Get the loan through a line of credit. Depending on your usable equity, you will get approved for a specific credit amount. You will pay interest only when you draw down on the loan. This is a beneficial strategy. However, you will require discipline so you don’t overspend just because you have cash available.
The collateralisation strategy involves taking equity out of your existing property as security for loans on both properties. You use your equity in one property as the collateral for both. However, the risk with this approach is that if you can’t repay the loan, the bank can repossess all your properties under the loan to recover the loan amount.
Step 6: Determine The Costs To Access Equity
The type of loan product you select and the equity amount you wish to access may lead to several costs and fees.
For example, you must pay Lenders' Mortgage Insurance (LMI) if you access over 80% of your property's value.
If you shift to another lender, you could incur fees linked to new loan application fees, breaking fees from a fixed rate product, and government charges.
Step 7: Loan Application and Settlement
Having decided on a loan option, your mortgage broker will work with you to execute the loan application process and assist you at each step to settlement.
6. Are There any Risks of Buying a Second Property with Your Home Equity?
If you buy a second property, you do not diversify your assets - you focus your wealth on one asset. So, if the property market drops, it will also reduce the value of your home.
Also, if you don’t use your equity wisely, it could lead to losing your home and investment property.
Tips to maximise the power of your equity safely:
Maintain an adequate buffer, and don’t use all your home equity to invest in property. This will prevent you from borrowing money in emergencies.
Repay the home loan as soon as possible before you focus on the investment. This way, you can access more equity and use it whenever required.
Property investment is a substantial financial commitment. Investing in the wrong property can cause you a massive loss in investment value. Ensure you educate yourself about real estate investment and pick a suitable property in a high-growth area.
All lenders don’t have the same policies. Your previous loan could have different terms and conditions than the cash-out loan. Thus, look into the new lender’s policy before refinancing it to determine whether the conditions suit you.
Get help from a professional financial advisor to understand your loan options, how much usable equity you have, and whether using equity for investment property purchase is suitable.
7. Frequently Asked Questions (FAQs)
How Much Deposit Do You Need For an Investment Property?
In the case of an investment property, most lenders require 30% of the home's purchase price as an upfront payment.
Is it Better To Use Equity or Cash?
You need a substantial equity margin upfront and good cash flow to invest in real estate.
Buying with “in-built equity” enables you to purchase, rent, rehab, and refinance your property. It safeguards from the risks of leverage and allows one to capitalise on its upsides.
Cash, on the other hand, is liquid money and is essential when financing real estate. Compared to a home equity, it is more convenient to use if things go wrong.
How Much Debt To Income is Too Much?
Lenders may not qualify you for a home equity loan if your debt-to-income (DTI) ratio is above 43%.
To calculate DTI, you must divide your monthly debt payments by your gross income. Lower DTI is more attractive to lenders as it indicates you have more room in your budget to take out a new loan.
Do You Still Need a Deposit if You Have Equity?
Lenders will usually allow homeowners to borrow up to 80% of the equity in their property, minus remaining debt, to buy a second property.
You will still need a deposit to pay the remaining 20% of the house purchase price to buy it. You can use the equity in your existing home to pay the deposit.
However, suppose your “usable equity” falls short of the required deposit. In that case, you may still need a deposit even after using equity for the payment.
Can I Use My House as Collateral To Buy Another House?
Most banks won’t allow you to use one home as collateral when purchasing another. However, you can indirectly use the equity you have built in your existing home in the following ways:
To buy another home (based on the amount of equity and the market price of the second home)
To leverage the purchase of another home
However, the drawback of using equity in one home to buy another is the chance of losing one or both houses if you can’t make the payments.
How do You Buy A Second Property Without Selling The First?
One of the ways you can purchase a second house without selling the first is to rent out your existing home as an investment property.
A unique rule known as the "six-year rule" allows a property that was once your main residence to remain exempt from Capital Gains Tax (CGT) if it's sold within six years of being first rented out. However, this exemption is applicable only if you don't designate any other property as your primary residence.
After this period, the ATO will consider your home as an investment property, and it will attract Capital Gains Tax if you sell it.
What Credit Score Do You Need for a Home Equity Loan?
Lenders usually want a credit score of at least 700 to approve you a home equity loan.
Interest rates are better for borrowers with higher credit scores. If you have a credit score of over 700, you can get a loan at a lower interest rate.
What Are The Disadvantages of a Home Equity Line of Credit?
A line of credit loan implies that the lender approves a certain credit amount based on your usable equity. You only pay interest on the credit amount you use but could get tempted to access it for futile luxuries.
Other drawbacks of a line of credit include:
You pay a higher interest rate than other type of loans
You don’t get any grace period for spending with a line of credit
You usually need a good credit score to qualify for it
Line of credit can be a great help in a temporary cash crunch. However, it can also lead to overspending if you don't use the amount responsibly. By performing due diligence, you can ensure the line of credit you choose maximises the power of your finances.
How Much Equity Do You Need To Buy a Second Property?
Lenders will usually permit you to borrow up to 80% of the accessible equity in your property to buy a second property. You can pay the remaining 20% of the deposit using built-up equity (minus outstanding debts) in your existing house.
For example, if you want to buy a property worth $500,000, you need 20% of the property’s market value as a deposit and a $400,000 home loan.
So, you need $100,000 worth of equity in your existing house to pay towards a 20% deposit.
Can You Cash Out Equity?
Yes. You can cash out if you have built up sufficient equity in your property.
Use the home equity calculator to find how much equity you can cash out to pay “as a deposit” to fund your property purchase. This information will help you better understand your loan options.
Obtaining an equity home loan can help broaden your property investment portfolio without cashing out.
Other purposes include:
Minor cosmetic renovations
Buying a business or investing in your industry.
Some lenders would require evidence of the purpose of the loan if you release over $10,000 to $50,000 as cash out. This requirement is incredibly stringent in the case of a low-doc loan.
How Much Can You Borrow Using Equity?
You can use the usable equity of your existing home “as a deposit” to fund 20% of the property's price.
You can approach a lender for a home equity loan to fund the remaining 80% of the property price. So, you can borrow 80% of the property price as a home equity loan from a lender.
How Much Equity Do You Need for a Second Mortgage?
Here are a few financial requirements you need to meet to qualify for a second mortgage:
A credit score of 620 or higher
A debt-to-income ratio of 43% or lower
A decent amount of usable equity in your first home.
As you use the equity in your existing home for the second mortgage, you will require enough to take out the second loan and keep approx - 20% of the home’s equity in the first mortgage.
Does Using Equity Increase Your Loan?
A common question real-estate investors have is - Does using equity increase repayments?
Yes. Accessing your equity in your existing home can increase how much you owe and the interest charged. This means that your home loan repayments will rise.
Using equity for refinancing will impact your current loan term and increase the debt on the existing home loan. This implies that you are taking the loan with a higher loan term than what is left of the original loan.
Is it Good To Use Equity on Investment Property?
Using existing equity to buy more properties helps them enter the property market at today's prices and take advantage of price growth than if they had waited years to save the deposit.
Over time, adding more properties to your investment portfolio will benefit you with the power of compounding. Each time the property market rises, your property value and useable equity also rise. However, the reverse can also happen.
Can You Borrow 100% of Your Equity?
No. Lenders usually allow you to borrow up to 80% of the equity in your property, minus unpaid debt, to buy a second property.
How do You Use Equity To Buy Another Property in Australia?
A popular option to use equity is to purchase a house or an investment property with equity. There are three options on how you can take equity:
A lump sum
A line of credit
Can You Use Equity as a Deposit?
Yes. Equity gives borrowing power to a property investor.
With adequate equity, you can use it as a deposit and borrow 80% of the property value to buy an investment property without using cash.
So, yes, you can use your equity in your property as a deposit against an investment loan.
Can You Use The Equity in My House To Buy Another Property?
Yes. Equity is a powerful tool for any property investor to grow their portfolio faster.
One of the good things about owning a property is that you can use the equity as a deposit for various investments and non-investment purposes.
Although this strategy has several benefits, there are some risks, too. Weighing its pros and cons based on your circumstances and investment goals will help you make the right decision.
|The advice and information on OzStudies.com is in general nature and should not be seen as a replacement for independent financial advice. We strongly encourage readers to consult with financial experts regarding their own financial decisions and investments.
Please note that the information presented on OzStudies.com is solely for educational purposes. Every individual's financial situation is unique, and the products and services we mention may not suit everyone. We do not provide financial advice, advisory, or brokerage services nor endorse buying or selling specific stocks or securities. It's essential to know that information might have changed since publication and past performance does not guarantee future results.
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