If you’re planning to buy a second property, the chances are you will need to use the equity on your current home to finance your new purchase.
Home equity loans can be a handy tool for property investors, allowing them to build a property portfolio using the growing value of their assets. But, as is always the case when increasing your debt, many investors can get themselves into trouble if they haven’t properly planned their repayment strategy.
Let’s look at what home equity loans are and how they can be used to build a property portfolio.
What is home equity?
The equity on your home is essentially the current value of your property minus the debt that owe on it.
For example, if you own a home valued at $600,000 and you still owed $350,000 on your home loan, then your equity would be worth $250,000.
Your equity will typically build as the value of your property grows and you continually make payments on your mortgage. As this happens, you have the potential to borrow against your equity to fund renovations, investment properties and other purchases.
Equity is also a crucial asset for later in life as it can reduce dependence on superannuation and the pension.
It’s important to differentiate between your total equity and your usable equity because this will determine how much of it you can tap into.
What is usable equity?
Usable equity refers to the amount of equity in your home that the banks will let you borrow against.
As a general rule, this number works out to be 80% of the current value of your home, minus what you owe on it. There are some instances where 80% isn’t the benchmark, but as you breach above this level to access a higher equity figure, then lenders mortgage insurance can come into play. We'll discuss this further in future blogs.
This means if your home is valued at $600,000 and you are owing $350,000, then the equation would be:
$600,000 x 0.8 = $480000
$480,000 - $350,000 = $130,000
In this example your usable equity would be $130,000 which you can borrow against for a deposit when purchasing another property.
That being said, lenders take many factors into consideration and may not allow you to access this equity if they are concerned about your ability to repay.
How do I use home equity to buy an investment property?
A home equity loan can be a handy tool to kickstart your property portfolio but it is not without its risks.
Leveraging your equity will allow you to take full advantage of Australia’s growing house prices by having a bigger stake in the property market.
For long-term investors, this is a great way of setting up multiple avenues of passive income that can support you through retirement.
As your portfolio builds, your equity will accelerate.
Historically, Australian property prices have substantially outperformed interest rates - meaning that acquiring more assets is often a fast and effective strategy to growing wealth.
Investors do have the choice to sell one or more of their properties later in life in order to service the debt owing on their other loans.
Despite this, it’s crucial you don’t overstretch yourself or let debt impact your quality of life. Money is a great servant but a terrible master, so always leave a buffer to protect yourself from life’s uncertainties.
Your first and most important step should be making sure you are able to keep up with the additional costs and repayments that come with an investment property. Defaulting on a loan could mean you end up losing one or more of your properties. To help avoid being caught out by higher repayments, check out our budget planning calculator to organise you weekly or monthly budget.
Overall, using equity to buy an investment property can be an effective strategy, depending on your individual circumstances. As always, we recommend you weigh up all your options and seek trusted professional advice when deciding what strategy is best for you.
To speak with a qualified mortgage broker, contact the Elephant Advisory team here.