How to Use Equity in Your Home to Buy Investment Properties
Being â€˜Financially Freeâ€™ starts at homeâ€¦
Understanding the Principles
If someone told you could invest in 2, 3 or more properties without selling your family home, would you believe them?
The key to being on the path of wealth creation and becoming financial free is to start at home, or rather; it all starts with your home.
There is a way of more safely leveraging equity in your family home to kick start the wealth creation journey – it’s simpler than what most people think and you may surprise yourself that you’re in a better position than previously thought to own your first (or next) investment property.
Sadly, not many homeowners are in the property investment space, either because they think they can’t afford it or it’s out of their comfort zone. When we talk to clients along these lines, the response we normally get is: “I have no surplus cash to afford another property”, “I’m afraid of losing the family home” and “how will I pay back the debt”?
The underlying theme we’ve discovered is that most people don’t know how to make debt safer. The ability to take on debt lies in knowing how to do it safer. If you were asked the following question how would you respond?
“If there was a way to pay back the debt (the bank) for 10 years even if you lost your job, would you take on more debt as this would be a safer option?”
With the right professional guidance and advice and with sufficient available equity, it’s possible to get a loan for an investment property and be in a position to fund any negative gearing for the next 10 years – even if you lost your job!
So What is Equity?
The first step in investing is to understand what the term ‘equity’ is. Put simply, equity is the difference between the market value of your home less how much you owe the bank against it. So if your home is worth $800,000 and you owe the bank $300,000, you have $500,000 in equity.
But this is only the first part of the equation.
Banks are very conservative, so they normally want to keep some equity available in case of any unknowns. In most cases, this is 20% (similar to the deposit they want). In this example, the bank would want to retain 20% of the $800,000 less any debt you owe them. So in this example, it would be: $800,000 by 80% ($640,000) less the existing $300,000 debt, which equals $340,000. This means the bank would be prepared to consider lending a further $340,000. The $340,000 is called the ‘available equity’ and this is the beginning of the journey. Think of this as a giant credit card. The bank may call this an equity loan.
So what value investment property can you buy with $340,000 of useable equity?
Well, a simple rule of thumb is to multiply your useable equity by 4x to arrive at the answer. Theoretically a bank may consider you for a loan of up to $1.2M for property off a $340,000 equity loan. BUT, it must be pointed out that it’s important to retain some of the original available equity against the home as a safety net, because having this as a financial buffer could help make the borrowings safer and most importantly, buy you time if things go ‘pear-shaped’.
The more prudent approach would be to use part of the available equity to purchase say a $600,000 property. The deposit and costs of say $145,000 comes out of your equity loan leaving you $195,000 in your equity loan. We call this your buffer - money for a rainy day, it is your safety net. With these funds you could do a renovation, pay for repairs, fund increasing interest rates or lost rent or any negative gearing. If used for negative gearing (which should only be a short tern cost for a better property and not to reduce tax) at say $10,000 per year, the buffer could fund over 10 years shortfalls which should make the borrowings safer. If the property did not grow in value or there were other major issues then you could always sell the property but you would do this in your own time and not by a bank forcing you. The buffer buys you time.
Any investment should be based on a good financial review so do not use this safety net to purchase just any property.
Some Tips to Get Started
1. Have your home appraised.
Learn what your property is worth in the market today and from there determine what your equity and available equity is. When it comes to the first, a professional appraiser would be required. So expect for the actual market value of your property to not always be what you think it is. Always base your calculations on the appraised value. In knowing the true market value of your property you can then calculate how much equity is locked in it and how much of that is available for a potential equity loan.
2. Get advice!
Surround yourself with a team of financial experts. Find a good mortgage broker, property tax accountant and financial advisor that can work with you to achieve your goals.
More specifically, get a financial borrowing strategy from a good mortgage broker and talk to a property specialist accountant to ensure you purchase the investment property in the correct name as this could also cost you significantly if it’s in the wrong name.
This article was written by:
Managing Director – Chan & Naylor
Chan & Naylor, National Property Business Tax Accounting & Wealth Advisory Group - Australia’s Fastest Growing and Top 100 Accounting Firm (BRW 2007, 2008, 2013)
For more information or to talk to a Chan and Naylor Property Tax and Wealth specialist click here
Disclaimer: This article contains general information. Before you make any financial or investment decision you should seek professional advice to take into account your individual objectives, financial situation and individual needs.