What is equity in your home?
The equity in an asset is its value, less any money owed on it.
For example, if your house is valued at $600,000 and the current debt is $250,000, the equity in the home would be $350,000.
Using equity: How does equity work?
With a mortgage refinance, it could be possible to access the equity in your loan, and this way you could be steps closer to buying a second home. Using the equity in an investment property to buy a home could work pretty much the same too. The equity from your home or investment property can be used as a deposit on a second property, while your current property becomes security on the new debt. Using equity could allow you to buy a second property with no cash deposit from your savings.
If the value of your home rises, the equity could too. A home's value may rise because of capital growth or dedicated mortgage payments. You could also increase the value of your home by making renovations (though you will need to consider the costs of materials and labor to do this).
Your lender will calculate your loan to value ratio (LVR) to ensure some equity is held as security. After this, you can determine how much equity you have after refinancing.
Here’s how that works:
You buy a property for $400,000 and put down a 20% deposit + associated costs 5-7% of the property value and borrow the remaining 80% ($320,000).
Over time if the property rises in value by $100,000, meaning the 80% mortgage is now only 64% of the value of the property.
You could refinance your mortgage and increase your home loan up to 80% of $500,000 possibly creating a cash pool of $80,000 which you can use as a deposit for a second property.
If you use the equity as a deposit on a second property, you will be paying off two home loans instead of one, so it’s important to ensure your cash flow will be able to handle this. Refinancing your current property to release equity could also mean you’re increasing the amount of debt on your current home loan, so you could be paying it off for longer and paying more in interest over the life of the loan.
How much equity do you need to buy another home?
Lenders will typically allow you to borrow up to 80% of the equity in your property, minus outstanding debt, to purchase a second property.
For example, Kelly buys a property worth $500,000 with a 20% deposit ($100,000) and a $400,000 home loan. At this point, her equity in the property is $100,000.
Over 10 years, if she pays $150,000 off the home loan’s principal (leaving $250,000 owing) and the property’s value increases to $550,000. Her equity in the house is now $300,000.
She wants to access some of her $300,000 home equity to use as a deposit on her next property. She’ll need to put down a 20% deposit (plus associated costs) on the new property, leaving her with 80% LVR.
In Kellie’s case, 80% of her property’s value ($550,000) is $440,000. Take away her outstanding debt of $250,000 and she’s left with her possible available equity of $190,000.
While her equity might be $300,000, her available equity is actually $190,000.
The additional associated costs of buying a home
Buying a house isn’t just about paying what’s on the property’s price tag. There are some extra costs all buyers should be aware of. These additional costs depend on the value of your property and where it’s located. Typically, you should factor in the following costs apart from your deposit.
Conveyancing and legal fees
Stamp duty
Building and pest inspection (combined)
Mortgage registration fee
Transfer fee
Loan application fee
Mortgage insurance (if applicable)
Council and utility rates
Using equity to buy an investment property
Equity could be one of the most powerful tools property investors have at their disposal because it could allow them to build their property empire faster. As mentioned above, lots of investors use the equity in their current property to buy another investment property. That property then grows in value allowing the investor to buy another investment property, and so on.
Over time, if you keep using this approach and adding even more properties to your investment portfolio, it could have a compounding effect: every time the property market rises, your property wealth and useable equity could rise too. On the other hand, if the property market falls, your wealth and useable equity could fall too.
Pros and cons of using equity to buy another home
Before you use a home equity loan for a second home, consider the pros and cons of taking equity out of your home to buy another house.
Pros
You might be able to get into the market at today's prices and reap the rewards of price growth than if you had waited and saved the deposit, which can take years.
You might have a better chance to reserve your cash flow. Using home equity to buy a second home keeps cash in your pocket that you would otherwise use for the home purchase. This increased cash flow could result in a healthier emergency fund or go towards other investments.
There might be an opportunity to increase your borrowing power. Buying a house with equity could allow you to make a larger down payment or even cover the entire cost.
You might be able to borrow at a lower interest rate than with other forms of borrowing. Home equity products typically have lower interest rates than unsecured loans, such as personal loans. Using home equity to purchase a new home could be less expensive than borrowing without putting up collateral.
Cons
You might be putting your primary residence at risk. Using a home equity loan to buy a new house can jeopardize your primary home if you’re unable to handle the payments.
Most likely you will have multiple loan payments. Taking equity out of your home to buy another house could mean you’ll potentially have three loans if you have a mortgage on both your primary residence and the second home in addition to the home equity loan.
Interest rates might be higher than on a mortgage. Home equity products have higher interest rates than mortgages, so you’ll be borrowing at a higher total cost.
You are potentially not diversifying your assets - you are instead possibly concentrating your wealth. If the property market drops, so could the value of your home and vice versa.
Jenice Lee at Finance Star is MFAA approved finance broker and is not your average mortgage broker.
Contact us if you want to find out more about how we can help with your finance options.
FINANCE STAR Credit Representative Number 529071 is authorized under Australian Credit Licence Number 389328.
This article provides general information only and has been prepared without taking into account your objectives, financial situation, or needs. We recommend that you consider whether it is appropriate for your circumstances and your full financial situation will need to be reviewed prior to acceptance of any offer or product. It does not constitute legal, tax, or financial advice and you should always seek professional advice in relation to your individual circumstances.
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