Being ‘financially free’ starts at home
Ken Raiss, Managing Director of Chan & Naylor, national property business tax accounting and ...
Ken Raiss, Managing Director of Chan & Naylor, national property business tax accounting and wealth advisors, outlines how to use equity in your home for investment purposes.
Understanding the principles
The key to being on the path of wealth creation and becoming financially free is to start at home, or rather; it all starts with your home.
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.
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?
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.
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 term 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.