Investing with the Use of Equity
It is a common misconception that your mortgage needs to be paid off before you can purchase an investment property. This is simply not true. With the use of your home equity, you could be well on the way towards building your property portfolio.
What is equity?
Equity is the value left over after subtracting the remaining amount of your loan from the current value of your home. For example, if your home is valued at $500,000 and the amount remaining on your mortgage is $300,000, your equity is $200,000. The equity can be borrowed against to secure an investment loan.
How to build equity
Equity changes by shifting one of two factors; The value of the home or the value of the mortgage. An increase in the home value or a reduction in the mortgage amount will grow your equity.
Increase equity by reducing the mortgage quickly
Thanks to compound interest, any amount paid above the minimum loan repayment will be chipping away at the principal amount to reduce the debt faster and lower the interest costs.
Making biweekly repayments rather than monthly will see you repaying the equivalent of 13 monthly repayments over 12 months. For example, a monthly repayment of $1,200 is $14,400 over 12 months. Split the monthly amount into biweekly payments of $600 and after 12 months you’ve paid off $15,600 – which is equal 13 of the original monthly repayments.
Contributing any work bonuses, inheritance or windfalls to your mortgage reduces the principal amount and directly increases your equity. The interest costs will be reduced meaning you’ll save money while growing equity.
Increase equity by increasing your home value
Generally speaking, property value tends to rise with time and consequently, your equity will increase as the value of houses appreciate. Short of waiting for the value of your home to naturally rise with the market, renovations and general touch-ups can increase value. Bathroom and kitchen renovations tend to drastically increase value while things as simple as a new coat of paint or landscaping can increase your equity also.
How much can you borrow against your equity?
Due to risk management factors, banks won’t lend against your total accessible equity. The amount they will lend against is called the usable equity and is calculated as 80% of the current valuation of your home minus the current mortgage.
From the example above, the accessible equity is $200,000 but the usable equity is $500,000 (home value) x 80% – $300,000 (remaining mortgage) = $100,000
To calculate the maximum purchase price of an investment property, take the usable equity amount and multiply it by four. In our example, this gives you a purchase price of $400,000. This method means you have enough equity to use as a 20% deposit ($80,000) on the new property (so you’ll avoid paying lender’s mortgage insurance) plus enough to cover stamp duty and other fees (which could cost as much as $20,000 on a $400,000 property).
Take caution when using equity
Using your home equity to purchase an investment property comes with the risk of losing both your home and your investment property. It is a decision that needs to be made after careful consideration and consultation with a professional before deciding if it’s right for you.