Equity can be an extremely powerful tool for wealth creation and property accumulation if structured correctly. In this article we take a look at how you can use equity to buy investment property.
What is equity?
Equity is the difference between the value of your home or investment property and how much you owe the bank.
For example if your home is worth $400,000 and you owe the bank $220,000, you have $180,000 in equity.
The great thing about equity is that you can use it as security with the bank and borrow against it:
- to live
- to retire
- to extend your home
- to buy a car
- to go on a holiday, or
- for any use the bank allows.
Most importantly, you can use the equity in your home to buy investment property.
Most banks will lend you up to 80% of the value of your home, minus the debt you still owe against it, although it’s possible to borrow up to 95% by taking out Lenders Mortgage Insurance (LMI).
How can you calculate the equity in your own home or investment property?
Value of your property x 80% = $________
Minus your debt = $________
So for example, using the method above, if the value of your home is $400,000 and your debt is $220,000:
$400,000 x 80% = $320,000
Minus the $220,000 debt against your home = $100,000 of useable equity.
Accessing the equity in your property is not always as simple as running the calculations above. Generally your lenders will send a valuer out to your property. Often the figure they come back to you with will not match up with your perception of local market values.
What affects your ability to access the equity in your own home or investment property?
Just because you have a heap of equity built up doesn’t mean you can borrow against it.
The banks will always take into account your income, dependents, debt, LVR and risk.
How can you increase the amount of equity available in your own home or investment property?
You can add equity / value to your own property through:
- Paying down your debt
- Purchasing properties which achieve strong capital growth
Adding value to your property is one way to speed up the rate at which you can access equity in both growth and flat markets. This means that while your mortgage has stayed the same the value of your property has risen, freeing up equity for future purchases.
How do you access the equity in your own home or investment property?
Once the value of your property has increased in value, whether that be through capital growth, renovation, or diligently paying your mortgage, it’s possible to re-access your equity as collateral to secure further lending.
This involves refinancing your mortgage at its increased value, thus freeing up some of its equity for you to spend on further investments. As discussed previously most banks will not release more than 80% without you paying LMI.
Just like your initial loan, your bank will calculate a loan to value ratio.
For example, if you have a $1 million property and you have a debt of $500k, the available equity is $500,000. If the bank lends 80% LVR, then you can take the usable equity of $400k to put into another property.
Line of credit vs. lump sum
One popular way to structure your home equity loan is as a line of credit.
A line of credit gives you access to a certain credit amount based on your usable equity. The benefit of a line of credit is that you only pay interest on the amount of money that you spend.
Your line of credit can also be linked to an offset account to reduce the amount of interest that your loan accrues, without increasing your repayments. For example if you have $20K in your offset account and have $500K loan, you’ll only be paying interest on $480K.
The risk of a line of credit is that it can be used like a huge credit card and just like a normal credit card the temptation will always be there to splash out on luxuries rather than investments.
An alternative to a line of credit is releasing equity as a lump sum.
The major problem with a lump sum, compared to a line of credit, is that you have to have to pay interest on the entire lum sum from day one.
Another means of using your home equity to fund a new investment is to cross collateralise.
This is a high-risk strategy, which involves using the equity from your existing property as security for loans on both properties.
The risk of cross collateralisation is that your loans will be linked by the fact that the equity in one property is used as the collateral for both. In other words, if you can’t service the debt on one of the properties, then the bank can repossess both.
Do your sums
At the end of the day equity can be an extremely powerful tool for wealth creation and property accumulation if structured correctly.
Before you start building your property empire you should develop a clear investment strategy.
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