Do you want to buy an investment property but don’t have the cash readily available for a deposit?
The good news is, if you already own a property, there is a way of buying a second home using equity instead.
Note: After all, property values are still far above pre-pandemic values, so it makes sense to take advantage of the equity boost in your home while you have it.
So if you're wondering how equity works when buying a second home, read on and find everything that second home buyers need to know.
Equity in a property is the difference between the current market value of your property and how much you owe on it.
So, for example, if you own a property worth $1 million, with current home loan debt of $500,000, then you have $500,000 worth of equity.
But note, there is a difference between the equity in your home and what is deemed usable equity.
I’ll discuss this in more detail shortly.
The great news is that you can use the usable equity you have accumulated in your first property to help buy a second home - you would do this by using the equity as security for getting a deposit to buy your second property with a lender.
Essentially, that means that instead of saving another deposit, you can use the home loan payments you’ve already made to assist you with buying a second home.
Calculating usable equity
When you apply for your first home loan, a bank won’t lend you the full amount of the property value you’re trying to buy.
And buying a second home using equity is similar in that your lender won’t lend you the full value of your current property.
Instead, a lender will calculate what they call ‘usable equity’ which is typically equivalent to 80% of a property’s market value minus the remaining balance on your mortgage debt.
Here’s a calculation example:
- Your home value is $1 million
- 80% of $1 million is $800,000
- Your debt is $500,000, so subtract this from the 80% figure and you’re left with $300,000
- This means you have $300,000 in usable equity.
Keep in mind that while equity gives you borrowing power and can be used as or towards a deposit, you’ll also need money to cover stamp duty and settlement costs so you might still need to make a cash contribution.
It is, however, possible to buy an investment property by borrowing more than 80% but you’ll incur the cost of Lenders’ Mortgage Insurance (LMI) which will be around an additional 2-3% of the loan amount, and your interest rate might be a little higher as a result.
The banks will also take your servicing capacity into account to determine how much you can afford to repay.
This is especially important in the current market when interest rates are high and likely to remain so for a while.
Calculating accessible equity
Accessible equity is another term to calculate the same thing - some lenders call it “usable equity” and some refer to it as “accessible equity.”
Either way, accessible equity is the equity that you can actually access on your property, which is lower than your total home equity - with 80% being the guide unless you pay LMI.
When it comes to working out how to access your home equity, there are 6 options to consider: refinancing, a line of credit, cross-collateralisation, a reverse mortgage, offset savings, or a redraw facility.
When you’re looking at buying a second home using equity, the first thing you’ll want to consider is refinancing your property.
Refinancing means you’ll be moving your home loan to a different home loan product, or even moving to another lender altogether.
It is one of the most simple ways to access your equity as the process of refinancing your mortgage will release your usable equity as a lump sum.
Tips: While this is the most common method many bankers will recommend, if your second property is going to be an investment property - definitely do not go down this route!
You see... Getting one be alone me that part of this loan will be for your home (which is non-tax deductible debt), and part of the loan will be for an investment which is a tax-deductible debt.
Mixing the two leads to an accounting nightmare
2. Line of credit
Another option is to apply for a line of credit, which means that you’ll be approved a certain credit amount based on your usable equity, but you’ll only start paying interest on whatever portion of that amount that you decide to spend.
The benefits of a line of credit include that it is a separate loan from your original home loan (see above) and that you’ll only pay interest on the amount used, unlike if you get a lump sum where you have to pay interest on the entire amount.
A potential disadvantage of this option is that a line of credit is effectively a huge credit card’ secured by your property, and just like regular credit cards, the temptation may be there to splash out on luxuries rather than investments, which could put you in hot water quickly.
Another option for buying a second home using equity is to take equity out of your property using cross-collateralisation.
This strategy involves using the equity from your existing property as security for loans on both properties.
So instead of releasing your equity to use as a deposit for buying a second property with a second loan, your loans will be linked and the equity in one property is used as collateral for both.
The danger is that if you are unable to make payment on the loan, the bank can repossess all properties under the loan.
4. Reverse mortgage
Homeowners over the age of 60 have the option of using a reverse mortgage to leverage equity to buy a second home.
The key to a reverse mortgage is that you can stay in your home and won’t have to make repayments as long as you’re still living there - so it’s a great solution for older Australian homeowners wanting to buy an investment property.
The amount you can borrow also increases with your age as each year the proportion of your property’s value that you can borrow grows.
However, while you won’t have to repay the reverse mortgage until the point of sale, interest will still be charged and compounded over time.
The amount you can borrow with a reverse mortgage starts at 20% of the property’s value at age 60, increasing by 1% for each year of age up to 90 years old.
5. Offset savings
An offset account is an everyday bank account that's linked to your home loan. You can deposit your salary and savings into the account and the balance is then “offset” against the amount owing on your home loan.
It gives you the ability to use your savings to reduce the interest payable on your loan.
So if you’re always been vigilant in putting your savings or extra income into your offset account, this can also be another easy option for accessing extra funds against your mortgage.
You can simply withdraw any additional cash from your offset account to put towards buying a second home.
Alternatively, an offset account is also important when thinking about withdrawing as a lump sum - as per the refinancing option above - because by moving any lump sum equity withdrawal into your offset account, you won’t pay interest on that lump sum until it's withdrawn from your offset account.
6. Redraw facility
A redraw facility allows you to access additional repayments that you've made on your home loan over and above the minimum required repayments.
So, if you’re in the habit of paying more than your scheduled repayment, or topping it up, you might have money you can withdraw from the loan.
The amount you can access for redraw depends on how far ahead you are on your mortgage repayments, and there is usually a minimum or maximum amount you can withdraw.
While the benefit of a redraw facility is that it is usually cheaper than using a credit card or personal loan, the downside is that you are still using your original home loan for potential investment purposes and the tax implications could be horrendous.
Just to make things clear...
It is not the security against which you borrow the money that decides whether the interest is tax-deductible, but the purpose of the loan.
When you initially took out your home loan the purpose was to buy a home and this means the interest on this loan is not tax deductible.
Now you can still use your home as security to get the deposit for your second property, but it really must be a separate, stand-alone loan; even though the security for this loan would still be the same residence.
Buying a second property using equity has some advantages:
1. Access to extra money
The key benefit of buying a second home using equity is that it helps property owners buy more property without having to save or accumulate a cash deposit.
2. It helps property investors grow their portfolios faster
Essentially, because you don’t need cash upfront for each property purchase, it helps property investors grow their property portfolios faster because they can use existing properties to buy more investment properties - the more properties you own, the more equity you can accumulate and therefore access to buy more properties.
It’s a popular investment strategy with a compounding effect that supercharges property investors’ income and asset value over time, building the ultimate property investor goal of a passive income.
Buying a second property using equity also comes with several risks, which need to be considered before you decide to go down this route, and what option to take.
1. Falling into negative equity
The most significant risk associated with buying a second property using equity is falling into negative equity.
If market conditions go against you, it’s possible your market value will sink below the balance in your home loan
That’s because gearing works both ways, if the property value increases you have a larger available equity and if it falls then the equity falls with it.
2. You could risk losing your property (or both properties) if you fail to make repayments
If you utilise an equity loan to purchase a new property, you risk losing your primary residence if you can’t make the payments.
3. Your repayments will be higher
Because you’ll now have to repay both 80% of your first property, and the loan on your second property, your home loan repayments will be higher.
However, if you use the funds to buy the investment property the rental in depreciation allowances should go quite some way to funding your interest payments.
Second-home buyers can look at ways to boost their property’s equity to either increase the amount of usable equity they can then access, or simply to pay off their loan(s) quicker.
Renovating to boost the property value
When the value of your property rises, the equity in that property rises too.
A quick way to boost your property’s value is by making some sensible renovations.
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You’d need to do thorough research about exactly what renovations will add value to the property, and you’ll need to consider the costs of materials and labour needed to complete the renovation.
Keep it cosmetic.
Buyers and tenants will pay more for things they can see - they don’t really care that you’ve spent all your money restumping, re-roofing, and rewiring.
You need maximum bang for your renovation budget to avoid over-capitalising on structural changes that essentially add no tangible value.
So aside from painting walls and upgrading flooring, window furnishings, and light fittings, the only other works I would seriously consider are updating or replacing the kitchen and/or the bathroom.
This is usually where you get the best bang for your renovation bucks spent.
Second-home buyers can also look at maximising their loan repayments to boost their property’s equity.
You see…the frequency of your loan and interest payments can make a big difference to how much you pay in interest over time.
If you think about it…there are 12 months in a year, but 26 fortnights and 52 weeks, fortnightly, or weekly payments can help you make an extra month’s worth of monthly repayments each year without really feeling it.
This helps build equity in your property and reduces the number of years it takes to pay off your home loan.
They can also make additional one-off contributions to repay your home loan faster and boost your equity - this is especially helpful if you have the type of job which pays bonuses or commissions on top of a salary.
Making a large deposit
The final way to boost your equity in a property is to make a large deposit when you buy the property.
After all, the more you put down, the greater your share of that property is.
Although not always possible, if you can get together more than a 20% deposit, you will also avoid LMI which can help to boost your equity further.
Note: Buying a second home using equity is a popular property investment tool that, if used correctly, can help to boost your property portfolio and help you reach the goal of passive income faster.
But it’s important to remember that just because you have the equity available, it doesn’t mean you should access all of it, and all at once.
READ MORE: Buying a property with equity in Australia