If you’re looking to grow your property portfolio, a powerful tool may already be at your disposal: the untapped equity in your existing home or investment property.
Let’s explore what property equity is, how it can be leveraged to buy another property, and whether this strategy is the right fit for your financial goals.
What is equity?
Equity is the difference between a property’s market value and the amount owed on the mortgage. For example, if a property is worth $500,000 and the mortgage debt is $300,000, the equity is $200,000.
Equity can accumulate over time as a result of paying down the mortgage or through an increase in the property’s market value. Capital growth, which is when the value of a property increases, can help you accumulate equity. This is particularly relevant in booming property markets, where prices can rise significantly over time.
It’s important to remember that equity is based on the current market value of your property, not just the original purchase price. If you have renovated your home since purchasing it or haven’t had it valued in a couple of years, you could have more equity than you realise.
To understand how much equity there is in your home, you will need to get a property valuation from a bank. Getting a valuation gives you true transparency on what your equity position is before you make any decisions.
How to use equity to buy another property
Smart investors should look to capitalise on their “lazy equity” (or untapped equity not currently being put to use) to maximise their portfolio’s worth. A key strategy is to “recycle” your equity as quickly as possible. This means using the equity from one property as a deposit for the next, a process that can be duplicated to build a larger portfolio over time.
When you have a reasonable amount of equity in a property, you can access a portion of it – typically up to 80% – as security with the bank. This “usable equity” can serve as a deposit for your next property, which can either eliminate or significantly reduce the need for a cash deposit.
The ability to access this equity will still depend on your capability to service the additional debt. For example, if you don’t have sufficient income, it’s unlikely you’ll be able to access any equity at all.
Here’s a simplified example of how this works:
- Your home is valued at $1,000,000, with an outstanding mortgage of $500,000, giving you $500,000 in equity.
- You use $200,000 of this equity as a deposit for a second property, which is an investment valued at $800,000.
This process can be repeated to continuously grow your portfolio. With the right advice and financial structure, you can use your lazy equity to continuously grow your portfolio.
The process with banks and lenders
The process of using your equity to secure a new loan involves a few key steps and is where the expertise of a mortgage broker becomes important.
Property valuation
The first step is to get an up-to-date valuation of your property. A lender will arrange for a professional valuer to assess the current market value. This is crucial as it determines the total amount of equity you have. If you have recently renovated your property or have not had a valuation in a few years, you might be surprised by how much equity you’ve gained. It’s often prudent to obtain several valuations, as property valuations will tend to vary from valuer to valuer or lender to lender. The higher the property valuation, the larger the amount of equity that can potentially be released.
Equity assessment and usable equity calculation
Once the valuation is complete, the bank calculates your total equity. They then determine the “usable equity” you can access, which is typically up to 80% of the property’s value. This 80% threshold is important because borrowing more than this often triggers Lenders Mortgage Insurance (LMI). Avoiding LMI can save you a significant amount of money.
For example, if your home is valued at $1 million and you owe $300,000, your total equity is $700,000. Your usable equity would be up to $500,000 (80% of $1 million minus the $300,000 you still owe). You can actually release equity up to 95% of the value of the property, however this is likely to incur LMI above 80%. Some industries such as medical and certain postcodes can go up to 95% without paying LMI, so it pays to speak to a mortgage broker about what specific equity release options are available to you.
Application for a new loan
With the usable equity established, you can apply for a new loan. There are generally two ways to structure this:
- Refinancing with a cash-out: You can refinance your existing mortgage to a higher amount, effectively “cashing out” the usable equity. This new, larger loan would cover the original mortgage balance plus the funds you need for the new property deposit.
- Separate investment loan: A more common and often recommended approach is to set up a separate loan against the equity in your existing property. This keeps the loan for your primary residence separate from the investment property loan, which can be beneficial for tax purposes. Since interest on an investment property loan is tax-deductible, having a separate loan makes it easier to track and claim these deductions.
- Servicing the new debt: The bank will then assess your ability to service the new debt. This is a comprehensive review of your income and expenses. The bank will factor in the rental income from the new investment property to help with the serviceability calculation. However, they will often only consider a percentage of this rental income, such as 80%, to account for potential vacancies and management fees. If your income is not sufficient to meet the repayments on both your existing loan and the new one, you may not be able to access the equity, regardless of how much equity you have.
- Securing the new property: Once the new loan is approved, the funds are released to be used as the deposit for your next property. This is where you might want to engage a property professional or buyer’s agent to help you find the best investment purchase that is capable of providing high capital growth and strong rental yield.
Important considerations and risks
While using equity to purchase another property can be a powerful wealth-building tool, it comes with both rewards and risks. Here are some key factors to consider:
- Debt type: The debt on an investment property mortgage can be considered “good debt” because it is associated with an asset that is typically increasing in value over time. The interest on an investment property mortgage is tax deductible.
- Growth is taxable: When you own your own home, any capital growth on the property won’t be subject to capital gains tax. However, if you sell an investment property, shares, or a business, you will typically pay capital gains tax.
- Negative gearing and depreciation: If the income on your investment property is less than the costs of the property, you can also take advantage of negative gearing. This allows you to offset the loss against your taxable income. Another form of tax deduction is depreciation in which the ATO has a prescribed formula that allows you to claim some tax write-offs on the actual physical building and possibly the fixtures and fittings. Generally the newer the property the higher the depreciation and some tax write offs (generally fixtures and fittings) are only available to the first owner of the property or when you complete a renovation.
- Growth prospects: Unlike buying a home in your local area, you can invest in a property market in a growth phase and not be tied down to where you work and live. This can often give you better capital growth prospects.
- Professional advice: Before making any decisions, it’s crucial to seek the help of professionals. A mortgage broker and a financial adviser are a great place to start. They can help you understand the scope for potential borrowing, the impact on your cash flow, and ensure you don’t over-borrow, which can put unnecessary stress on your finances.
If you’re considering using the equity in your property to buy another property, it’s important to speak with your mortgage broker to help make a considered, educated decision. They will be able to advise on how to approach it and the pros and cons for your specific financial situation.
Looking to leverage the equity in your property for a property purchase? Reach out to Fabe Financial for a no-obligation chat today.