How to use your home equity to buy an investment property

It’s one of those concepts that can seem tricky to wrap your head around at first. What exactly is ‘equity' in your home and how can you access it?

If you are an existing homeowner, you could borrow against the equity in your current home to help buy an investment property. There are a range of options available such as loan top ups and supplementary loan accounts, so we’ve broken down the basics of what you need to know.

 

When talking about equity, there are two terms often mentioned: equity and usable equity. Usable equity is taken into consideration when applying for an investment loan. Let’s explore the difference.

What is usable equity?

As the name suggests, usable equity is the equity in your home that you can actually access and borrow against. You can work out the usable equity available by calculating 80% of your property’s current value minus what is still owing on the mortgage.

 

You can get an estimate of your usable home equity using this calculator.
 

Your lender or mortgage broker may require a formal bank valuation to determine the current value of your home and to calculate the usable equity you have available.

How can you use your usable equity to buy an investment property?

Leveraging the usable equity in your home may help with cash flow, freeing up funds that could be used as a deposit on a second home, with your existing property acting as a security on the new debt. There are several methods to borrow against the equity in your home to buy another property, each with pros and cons that you should weigh up.

It’s worth keeping in mind that even if you have enough equity built up, some lenders may not always allow you to access it. Lenders may take into account a number of factors such as your income, age, employment, family status, and any additional debts.

Home loan top up

One of the most common ways to borrow against the equity in your current property is to get a home loan top up or increase. This involves applying to increase your existing home loan limit to give you the funds (rather than a saving for a cash deposit). The top up amount is paid into your account as cash and you can use these funds to secure your investment property.
 

A home loan top up is dependent on a number of factors. Your first step should be checking with your lender to see if this option is available for your loan type.

If you’re contemplating a home loan top up, you’ll need to be in a position to make the extra repayments over the original loan term. By accessing the equity to pay for part of the investment property, you are borrowing more money and increasing the amount you owe on your home loan, therefore your repayments will also increase.

Leveraging your equity to top up your loan balance also means you will have more principal to pay interest on – and your loan term will stay the same. To get an indication of what your extra repayments may be, use a repayment calculator, like Westpac’s Mortgage Repayment Calculator.

Supplementary loan account

If you don’t want to increase your current home loan balance, another option is for you to use your equity to set up a new, supplementary loan account. This may allow you to choose different features from those on your current home loan. For example, a new repayment frequency, or type of interest rate (such as fixed rate).

When accessing your equity with a separate loan, you may decide to choose a loan with a different loan term. Keep in mind that this new loan could have a longer term than your existing one and might extend the number of years over which you pay interest on the entire loan.

Cross-collateralisation

Cross-collateralisation is another strategy some investors use to leverage their usable equity to purchase an investment property. This involves using the existing property as collateral and adding it to the new investment property loan to help with the purchase. In this case, you would end up with two loans:

1. Original mortgage secured by existing property
2. New mortgage secured by existing property and investment property

Cross-collateralisation may give you less flexibility than other ways of using equity. Having both securities tied up in one loan could mean more work to separate them down the track if you need to. For example, if you decide to sell one of the properties, your lender might need to rewrite the loan for the one you’re keeping, which would involve a new account number, loan contract and bank valuation.

What should I consider before accessing equity for property investment?

While leveraging the equity in your home to invest in a second property may sound like a great idea, there are several factors to think about before diving in.

The most important: make sure you can manage the extra repayments and costs that come with an investment property, especially if your property is negatively geared. Think about your cash flow and make sure you’ll be able to stay on top of things with your new repayments. You may find yourself managing different loans with different repayment amounts, schedules and loan terms – organisation is key.

Having a solid investment strategy and doing your research is also important. Long-term investment is a more reliable strategy, compared to short-term property investment – which can be risky. You want to avoid a situation where the property you’ve purchased is overvalued and you’re left with negative equity.

Remember that every method of using equity to purchase an investment property comes with a substantial risk: if you default on any of your loans, you could lose one or multiple assets. There are also tax implications to consider, so make sure you speak to an expert before you make a decision.

Before making the decision to access your usable equity, it’s a good idea to weigh up all the options, consider professional advice and decide what’s best for you and your financial situation.

Tips for investing in property

When looking to expand your property portfolio, it is important to have a carefully considered investment strategy and make decisions based on what will give you the best returns in the short term, and long term.

Top tips for selecting a property as an investment

• Make sure you research the local market and understand things like rental demand and property price trends.
• Map out and manage your cash flow. Estimate your potential rental income and outgoing expenses on a monthly basis – including strata, council fees, maintenance and of course loan repayments.
• Look for areas with solid capital growth. While it’s very hard to predict, avoid buying at the top of the market. If your investment is overvalued and loses value, you may find yourself with negative equity and making repayments on a property that may not give you a good return.
• Check the age and condition of the property and any facilities
• Think about the property maintenance requirements – properties with pools and large gardens may be costly to maintain.
• Picture yourself as a tenant – what are renters looking for in the market?
• Consider the type of property. Off-the-plan apartments are sometimes considered a risky investment – established properties are often a safer bet.

The Rule of Four

Wondering how much you should spend on an investment property? A calculation some property investors use is the ‘rule of four’. Simply multiply your usable equity by four to arrive at the answer.

For example, if you have $100,000 in usable equity, multiplied by 4 means your maximum purchase price for an investment property is $400,000. This ‘rule’ allows for a 20% deposit, therefore helping you to avoid lenders mortgage insurance (LMI). It also allows buffer room to go towards additional costs like stamp duty. This calculation could be helpful to determine if you have enough of a deposit and can manage the upfront costs of purchasing another property.

If you have less than a 20% deposit, you may have to pay LMI. LMI is a way for lenders to safeguard themselves against the risk of not recovering the outstanding loan balance if you were unable to meet your loan repayments.

Interest-only or principal and interest repayments?

When it comes to investing in property and your repayments, there are a couple of options for you to explore: interest-only and principal and interest repayments. But which one is right for you? Let’s dive in.

Interest-only

Some property investors set up a supplementary home loan that’s geared towards investing. One way of doing this is to take out a low-rate home loan for a shorter period (4-5 years) and opt for interest-only repayments during this time. By minimising the required repayments, you may get the benefit of freeing up your cash flow and leveraging potential market increases during the loan period.

At the end of the interest only period, you may choose to refinance or refix the loan and hold onto the property or calculate the equity in the investment. If the property has grown in value, you may decide to invest in another property to build your portfolio or sell the property and cash in the equity. The important thing to remember here is that an interest-only loan doesn’t reduce the principal loan amount, so your repayments will be higher when the interest only period ends.

Principal and interest

Principal and interest repayments are designed to repay your mortgage over the loan term – usually 30 years. As your loan balance reduces, so does the interest you’re paying (if the interest rate remains the same), which means your repayment pays off more of the principal, as the loan term progresses. You may also have the benefit of higher borrowing power and a lower interest rate with this option.

When paying principal and interest repayments, it’s also worth keeping in mind that your home loan repayments will be higher than if they were interest-only, which can impact on your cash flow if your rental income doesn’t cover the property’s expenses (like repayments, property management costs, insurance). The flipside is that every repayment helps to reduce your principal, which means you could pay your home loan off faster with this repayment type than if you were making interest-only repayments.

Want to learn more about investing in property? Request a call back from a Home Finance Manager or read further about equity in your home.