Buying an investment property with equity

Key takeaways

Equity in a property is the difference between the current market value of your property and how much you owe on it.

Useable equity is the amount of equity in your home you can access and use.

Equity gives you borrowing power and can be used as the deposit or part of the deposit used to buy an investment property.

One of the most popular options is to use equity to buy a house or buy an investment property with equity.

There are 3 options when it comes to working out how you take equity: a line of credit, a lump sum, or cross collateralisation.

Equity works both ways, meaning if your property value falls, it impacts the equity of your home. 

Do you want to buy an investment property but don’t have the cash in the bank for a deposit?

The good news is, if you’re an existing homeowner, there is a way to have your cake AND eat it.

And this is especially the case at a time when Australia’s recent property boom has seen existing homeowners’ equity skyrocket.

And you can put that equity to good use.

Here’s everything you need to know about buying an investment property with equity in Australia.

What is equity in the property?

Simply equity in a property is the difference between the current market value of your property and how much you owe on it.

For example:

If your home is worth $800,000 and the current debt on her home loan is $500,000, then you have $300,000 worth of equity in your house.

So while you may have thought of your home as a never-ending series of monthly loan repayments, with every payment you make you are building up your equity and over the last couple of years, with the market pushing property values, your home equity is lucky to have grown considerably.

How does equity in a property work?

The great thing is you can use equity without selling your home by using it as security with the banks.

This means you can borrow against your equity to fund things such as:

• extending your home
• starting a business
• buying a car
• going on a holiday
• buy an investment property

Note: There is a difference between the equity in your home and your usable or borrowable equity.

HOW TO CALCULATE YOUR USABLE EQUITY

Since the bank is lending you money against the value of your home, they won’t lend you the full amount.

Your useable equity is the amount of equity in your home you can access and use.

A bank will typically lend you up to 80% of a property’s market value.

Subtract from that the amount you owe on your home loan and the remainder is your useable equity.

Keep in mind that it’s possible to borrow more than 80% if you don’t mind incurring the cost of mortgage lender’s insurance.

Assuming you stick to the 80% ceiling, let’s do the sums to work out how much you can actually borrow:

• Your home’s value ($800,000) x 0.80% = $640,000

• Your debt is $500,000, so subtract this from the amount the bank will lend up to $640,000 and you are left with $140,000.

• This means you have $140,000 in usable equity.

If your usable equity isn’t enough to cover the full deposit plus stamp duty and settlement costs, then you will have to either make a cash contribution or it’s possible to buy an investment property with a deposit lower than 20%, but you’ll most likely have to take out Lenders’ Mortgage Insurance (LMI) and to pay an additional fee (approximately 2 to 3% of the loan amount), and your interest rates on the investment loan may also be higher.

HOW MUCH CAN YOU BORROW WITH YOUR EQUITY?

So essentially, equity gives you borrowing power and can be used as the deposit or part of the deposit used to buy an investment property.

However, your servicing capacity will determine how much you can actually borrow, and in the current era of rising interest rates, the banks will want to make sure you’ll be able to service your loan if interest rates increase in the future.

So what can you do with the equity in your home?

Some people refinance their original home loan and drawdown this equity by increasing their home loan and using it to fund their home renovation.

Others use it to fund that expensive European holiday they’ve always been dreaming about.

USING EQUITY AS A DEPOSIT

If you're looking to purchase a new investment property, you can avoid the deposit-saving process (and even avoid selling your home) by using the equity in your existing property.

Essentially you’re using your equity as a deposit.

The first step for buying a property with equity, or even building on your property investment portfolio, is to approach your mortgage broker or lender to request a valuation to assess your property’s fair and current market value.

If you’ve lived in your home for a while you probably have considerable equity in it.

This will then help you determine your usable equity as we discussed above.

The loan product you choose and the amount of equity you are looking to access may result in various fees and costs, such as Lenders' Mortgage Insurance as I’ve already mentioned or if you decide to switch to another lender, there may be costs such as fees associated with breaking from a fixed rate product, a new loan application fee or government fees.

How to take equity out of your property

When it comes to working out how you take equity out of your property, there are 3 options: a line of credit, a lump sum, or cross collateralisation.

OPTION 1: A LINE OF CREDIT

A line of credit means that you’ll be approved a certain credit amount based on your usable equity, but you’ll only start paying interest on whatever portion of that amount that you decide to spend.

But the downside is that a line of credit is effective ‘a massive credit card’ secured on your property.

And just like regular credit cards, the temptation will always be there to splash out on luxuries rather than investments.

OPTION 2: LUMP SUM

The second option is to release the equity as a lump sum.

Lump-sum equity release can be a useful strategy, but only if your investment plans justify the amount that you’ll ultimately be dishing out on interest repayments.

Because the second you withdraw that lump sum of money you’ll have increased your mortgage and will be repaying interest on the lump sum amount.

OPTION 3: CROSS COLLATERALISATION

The third option for how to take equity out of your property is to cross collateralise.

This is a strategy that involves using the equity from your existing property as security for loans on both properties.

So instead of releasing your equity to use as a deposit for a separate investment property mortgage, quite often with a separate lender, your loans will be linked by the fact that the equity in one property is used as the collateral for both.

The danger is that if for whatever reason, you’re unable to make payment on the loan, the bank can repossess both, or all, properties under the loan.

AVOID NEGATIVE EQUITY

Equity works both ways, meaning if your property value falls, it impacts the equity of your home.

Note: If market conditions go against you, it’s possible your market value will sink below the balance in your home loan, and this is something you want to avoid.

There are two ways you can help to avoid falling into negative equity:

1. Boost your regular payments so that you’re increasing your equity quicker and reducing exposure to any future market fluctuations.
2. Make additional one-off contributions to repay your home loan faster and boost your equity. This is especially helpful if you have the type of job which gives out bonuses or commissions.

A word of warning

But it’s important to remember that just because you have the equity there, it doesn’t mean you should access all of it, and all at once.

It’s also important to remember that lenders will also take your income, number of children, general living expenses, debts, and other factors into account when it comes to buying a property with equity.

Whatever you decide to do with your property equity, you need to ensure that it makes good investment sense.

It is also important to structure your investment loan correctly as a separate loan against your home rather than an extension of your home loan.

If done correctly the interest on this loan will be tax-deductible, even though the security for the loan is your home, because the purpose of this loan is for investment and income-producing purposes.

Credit: Brett Warren