Got Equity? Use It to Expand Your Investment Portfolio!
You own a property — fantastic!
Considering the current market conditions and inflation, owning a home is a massive accomplishment. What should you do next, though, to expand your portfolio?
One option is to take out the equity you’ve accrued in your home or investment and use it to make a deposit on a new property.
If you’re interested in this approach, this guide is for you. It answers some of the most important questions about using equity for future investment properties.
Disclaimer — The information on the Aurora website is intended to be general in nature and is not personal financial advice.
What Is Equity?
Equity is the difference between a property’s current market value and the amount of money you still owe.
For example, say your home is worth $800,000. If you currently owe $500,000 on your home loan, you have $300,000 of equity in the property.
You can use the equity in your home for numerous purposes, such as paying for renovations, starting a business, or buying a new investment property.
Usable Equity
It’s important to note that you typically can’t access all the equity you have in your home. Usable equity describes the amount you can access and use for purposes like buying an investment property.
Most banks will lend up to about 80 per cent of the property’s current market value. To calculate usable equity, subtract 80 per cent of the property’s worth from the amount you owe.
Let’s use the same example from above.
The house is valued at $800,000. Eighty per cent of that is $640,000.
If your debt is $500,000, you’ll subtract that from $640,000, which equals $140,000. That’s the amount of usable equity you currently have.
It’s possible to borrow more than 80 per cent. However, you will likely need Lenders’ Mortgage Insurance (or LMI) and will have to pay additional fees (around 2-3 per cent of the loan amount). You may also have higher interest rates.
How Can I Access Equity in My Home?
If you’ve done the math and decided that it’s worth it to use equity in your home, the next question to answer is how you can access it. You can choose between a few different options, including the following:
Line of Credit
A line of credit gives you access to a specific credit amount determined by your usable equity. You only pay interest on the amount of credit you spend.
Lump Sum
A lump sum gives you access to all the available usable equity. Remember, though, that it increases your mortgage (and you’ll have to pay additional interest on the lump sum amount.
Cross-Collateralisation
Cross-collateralisation uses equity from your existing property to secure a loan for it and the new property. Your loans will be linked instead of releasing equity to use as a deposit on another home.
The downside to this option is that if you default on the loan payments, the bank can legally repossess both properties (so do this with caution and appropriate financial advice).
Pros and Cons of Using Equity to Buy an Investment Property
Using your equity to buy an investment property can be an excellent option for those who want to expand their portfolios. However, it’s not a good choice for everyone.
Here are some pros and cons to help you decide if this is the best approach for you:
Pro: Larger Downpayment
If you use your home equity, you’ll likely have access to much more money than you’d have otherwise. This money allows you to put down a larger deposit on a new property, meaning you’ll have lower monthly repayments and, potentially, a lower interest rate.
Con: More Debt
Remember that when you use home equity as a downpayment on a new property, you’re taking on additional debt. You’ll have two home loans to pay back, which can put extra stress on your finances if you don’t plan properly.
Consulting a real estate or financial expert can help you avoid this issue and protect both of your investments.
Pro: Generate More Revenue
Buying an investment property gives you an opportunity to earn more monthly income. Renting out the investment property provides additional income that you can use to pay back the loan and minimise your financial burden.
Con: Higher Interest Rate Than a Mortgage
When you borrow against your home equity, you may have a higher interest rate than you would with a regular home loan.
A higher interest rate can add to your monthly repayment. However, if you choose your investment property carefully, you’ll get enough money back from tenants to manage the higher interest rates and pay back the money faster.
Pro: Potential Tax Benefits
If your loan is structured correctly (this is why working with an expert is so important), you can deduct the interest paid on the second property loan because you’re using it as a source of income. By deducting the interest, you’ll enjoy a lower bill when tax season arrives.
A Word of Warning
Before you run out to the bank and ask about a home equity line of credit or lump sum, keep these words of warning in mind:
- Just because you have equity, you shouldn’t necessarily try to use all of it.
- Lenders consider other factors when approving you for a second home loan, including your income, the number of children you have, your debts, and your general living expenses.
- If you use your equity to buy an investment property, choose carefully to ensure the property will yield positive returns.
When in doubt, ask a professional. They can help you decide if borrowing against your equity is a smart move and help you move forward with the process.
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