Buying an investment property is a great step toward creating a financial situation that will benefit you in the long run. You will often experience higher returns than investments in other assets, with the rental income supplying you with your own passive source of wealth.
If you own your house outright and want to buy another, you can use your gathered equity to buy the new property. This means that there is no need to dip into your life savings. Instead, your usable equity can cover what you need to secure a substantial deposit and avoid paying for a home loan that does not suit you.
What is home equity?
Home equity refers to the difference between the current value of your property and the remaining balance you owe for it.
With the monthly home loan repayments you make in the form of principal and interest repayments, your total home loan amount owed has been reduced, allowing your total equity to steadily increase. Additionally, if the market value of your property has increased, your equity will also see significant growth.
Total vs useable equity
The term total equity is generally used to define the amount of existing equity in your home. It is not to be confused with usable equity, as the former does not indicate how much borrowing power you actually have.
Usable equity is the amount of actually accessible equity you can use to buy an investment property. The amount of available equity in your home is calculated as 80% of your property’s market value, minus the remaining balance left in your home loan.
How is equity calculated?
To calculate the total amount of equity in your home, you need to know the value of your property as well as how much money you have left owed for it. This amount owed is taken from the property’s value to distinguish how much equity you have in total.
For example, if your property is valued at $850,000 but you still owe $500,000 in loan repayments, your total equity will be calculated as $350,000.
In contrast, the usable equity is calculated as 80% of the property’s value minus the remaining amount owed. In the same scenario as a house being valued at $850,000, with $500,000 still owing, you can access equity that amounts to $180,000.
How does equity work when buying a second home?
When looking into buying a second property, especially if it is an investment property, your first thought should be how you will cover the cash deposit needed to secure the property, as well as the necessary investment loan. This is where equity comes in to alleviate mortgage stress and set you on the right path of property investment.
Any instance of borrowing money from a financial institution or mortgage broker to help cover the cash deposit comes with an overview of your finances and capacity to make repayments. This includes your loan-to-value ratio (LVR) to the new property investment, which is also defined as the percentage of the property’s value you wish to borrow.
Typically, a lender will offer up to 80% LVR on the value of your investment property, minus the debt owing, so long as you can make repayments. However, having equity to buy an investment property means that you will not have to rely so much on a lender and their offering of LVR to cover the deposit bonds. This will allow your new home loan to be favourable to you and your circumstances.
Calculating how much equity you need to buy a second property
In order to calculate how much equity you need to buy an investment property, you need to be aware of the amounts associated with your existing property value, the 80% LVR total, as well as how much more debt you owe.
This amount should cover the 20% deposit needed for your new investment property. By covering the full 20%, or at least as close as you can get to this percentage, you will not owe your lender a significant amount for your home loan. Requiring less to borrow also means paying less for interest repayments and having a shorter home loan.
Using the Rule of Four
To help calculate the amount of equity you should spend on an investment property, some property investors utilise the ‘rule of four’. In short, the rule dictates that the maximum purchase price of a property investment should be no more than four times your usable equity. This allows coverage of the 20% deposit and most additional fees associated with purchasing a property, helping you to determine whether or not you have enough equity to cover the costs of property investment.
For example, $200,000 in usable equity means that your maximum purchase price should come to $800,000. Any less and there is a chance you may have to pay for Lenders Mortgage Insurance.
How to use equity to buy an investment property
Utilising equity to buy an investment property comes with several benefits, with the main one being a provision of cash flow that does not dip into your life savings. This alternate source of wealth is capable of covering a property’s deposit, with your existing property also acting as a security measure for the new debt.
These benefits are consistent, regardless of what method is used to access equity and apply it to property investment. However, even with sufficient property equity, a lender may still not allow you to access it. This is often due to other factors they observe before granting a home loan, which includes age, income, employment, and existing debts, amongst others.
It is important for your personal and financial affairs to be in order before applying for a home loan or buying an investment property. Having these affairs organised will make the process of accessing your equity far smoother in the long run.
In order to begin accessing equity, the steps you must take are:
Home loan top up
One of the most common methods of using equity to buy property investment, a home loan top up involves applying to increase your existing home loan limit. By doing so, you can access funds immediately, rather than using your savings.
Choosing this method requires you to be capable of making extra repayments over the original loan term. This is because accessing the equity in your home means borrowing more money, which in turn increases the amount you have to pay on your loan balance. Thus, your repayments will need to be increased, and you will have more principal to pay interest on in the future.
Supplementary loan account
If you do not want to increase your existing home loan balance when expanding your property portfolio, you can choose the method of opening a supplementary loan account with your equity. This allows you to choose what features your new loan will possess, such as the type of interest rate used or the frequency of repayments.
Cross-collateralisation
Property investors seek out this method to use their equity as leverage for the purchase of an investment property. It uses the existing property as collateral while also adding it to the new loan to aid with the purchase price. Using this method will leave you with two mortgages:
- The original mortgage as acquired for the existing property
- A new mortgage that combines the original property with the new property investment
Although this method could mean facing some difficulties in untangling your properties from each other, it is often appealing to those who want to manage their property portfolio in one go.
Additional factors that lenders will consider
Beyond how much equity you have available, your lender will also consider several financial and personal factors in your life to determine if you are trustworthy enough for a loan. Some of the more common factors a lender will consider include:
- Your income and how stable it is
- Your age
- If you have dependents or not
- If you have outstanding debt
- Your credit score and history
- Your debt-to-income ratio
- The value of your collateral
- Available assets
- And more.
Other uses of home equity
Obtaining a mortgage or buying a new property are not the only uses for home equity. By accessing this fund, you can finance multiple decisions and investments, including:
- Home renovations
- Covering a car loan
- Financing a holiday
- Investing in shares and other assets
- Starting a business
- And more!
What to consider before using equity for property investment?
Before using equity to buy an investment property, you need to consider the factors and fees that are included in this payment method. Namely, ensuring that your finances can cover the extra repayments and costs that come from owning more than one property, particularly if your original property has negative equity.
Preparing a payment plan and managing your finances accordingly can make the transition to owning two properties far easier. This may mean setting up different loan rates and terms for each property and its loan, so long as you ensure a steady cash flow is maintained for both.
You also want to guarantee that you choose correctly out of the investment properties currently on the market. This means thinking of long-term investment, rather than short-term so that you come out the other end of your loan in the positive. Always consider the risks that come with having to pay interest repayments, taxes, and fees on a second property, as well as how to prevent yourself from defaulting on a loan.
If you are unsure of whether to use equity for property investment, speak to one of Homestar Finance’s home loan specialists today. Our team of specialists can walk you through the process of using equity to buy investment properties or, if you are ready to take that first step, we can provide pre-approval for a home loan. With our expert advice and ongoing support, you can be sure to make the right decision for your finance’s future.
Learn more about equity for property investment!
Contact one of our trained loan specialists at 1300 231 948 to learn more about to get started on your new home loan today
Disclaimer: This article is not intended as legal, financial or investment advice and should not be construed or relied on as such. Before making any commitment of a legal or financial nature you should seek advice from a qualified and registered Australian legal practitioner or financial or investment advisor.
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