If you own a home, and bought it for a fair price in a growth area, chances are it’s going to increase in value over time. A lot of experts claim property roughly doubles in value every 10 to 15 years (shorter if you live in Sydney or Melbourne). So when the value of your home increases, the gap between what you owe the bank and what you would get for the property if you sold it widens. This is referred to as the ‘equity’ in your home.
A lot of our clients have had their home for some time, have partly repaid their mortgage and as a result have hundreds of thousands of dollars in equity.
So what does equity do?
As the owner of your home you make the decisions: Your equity can just sit there doing nothing, waiting for the day you decide to sell and put it towards purchasing a new place to live, or you can use it to invest and grow your assets.
Most would-be investors use their equity, or a portion of it, to put down a deposit on an investment property and pay for stamp duty and other related costs. Any remaining funds can help as a buffer once you own the property, just in case some unexpected expenses come up.
You might consider using any surplus funds to trade shares or invest in financial products but keep in mind that this is somewhat more risky as there is little or no leverage.
How can you get at your equity?
That is apart from selling your home – which you probably don’t want to do! There are other (and usually better) ways to access it.
The smart way to “extract” this equity is to set up a bank facility and, as there are many products out there at different rates and conditions, it’s probably best to talk to a good mortgage broker. Their specialty is to be familiar with all the financial institutions, what their current deals are and find the one best for you.
Generally a bank will lend you 80% of the value of your home, less whatever outstanding debt you have on it. So the longer you’ve owned it, and the more you’ve paid down your loan, the higher the amount you can access.
You obviously don’t need to use it all but, as a guide, to purchase a $500K investment property you need to extract about $200K equity. This is made up of, say, $130K for the deposit, stamp duty, legal fees, etc. and the other $70K would be your “buffer”, just in case.
Here’s an example:
Tom and Linda have a home worth $1 million with a mortgage of $500K.
Their mortgage broker calculated they could “extract” $300K ($1million x
80% less $500K existing debt). For their investment they only needed
$200K so could easily go ahead with their purchase.
After doing their research and seeking advice from an investment property professional, they decided to acquire a $500K investment property. The broker organised a $400K loan (80% loan to value ratio) secured by the new investment property and the other 20% (ie the deposit) + stamp duty + legal costs + other expenses) came out of the funds they extracted. With their buffer in place, Tom and Linda were comfortable with their cash flow and capital growth projections.
It sounds scary to borrow everything to acquire an investment property, but it makes a lot of sense because your tenant and your tax refund will pay for a big chunk of your expenses. So you will only need to finance any shortfall (if required, as properties can also be cash flow positive).
It can be a sound strategy
As long as you have enough income to service the debt, you can replicate this strategy when the equity in your own home increases further and you gain equity in your investment property too.
Borrowing to invest in property is a common investment strategy which can provide a rental income as well as capital gain, and can make the difference between a ‘comfortable’ and ‘frugal’ retirement.