Equity is defined as the difference between the current value of your home and how much you still owe on it, and it can be the difference maker in allowing prospective investors to buy a second property.
Put simply, if your home is worth $900,000 on the market and your mortgage is still owing $620,000, your equity is $280,000.
In reality however, you often can’t use all of your equity to buy another property, you have to calculate your ‘usable equity’ first, because it’s common practice to be able to borrow up to 80 per cent of the value of your home, primarily so that banks cover themselves against any possible dips in house prices.
So, in the previous example, to calculate your usable equity you take 80 per cent of the value of the home ($900,000 x 80% = $720,000) and subtract the outstanding debt ($720,000 - $620,000) to leave you with $100,000 of usable equity you can put towards a deposit for an investment property, or indeed, other life purchases like renovations, buying a car or starting a business.
With your $100,000 of usable equity in hand, you can now hit the property market looking for an investment.
A good guide to know how much borrowing power you have with your usable equity is to multiply it by four. The ‘rule of four’ means if you have that $100,000 ready to go, you can start looking at property worth around $400,000.
Lending institutions will generally lend against 80 per cent of your property investment, unless you take out lenders mortgage insurance, which is another added cost.
If you don’t take out LMI, it means the bank will lend you $320,000 for your prospective $400,000 investment, which of course leaves you $80,000 short.
Remembering there’s $100,000 of usable equity in your hand, that covers the $80,000 shortfall as well as the extra purchase costs of stamp duty and settlement fees which come to around 5 per cent of a property price, which in this instance is $20,000.
The $80,000 and $20,000 costs add up to your $100,000 of usable equity, and you can now hit the property market in search of a savvy investment worth up to $400,000.
While this example can be used as a general rule, the bank will look at factors such as your current income, age, dependents and how much debt you hold before lending you the full amount against your home equity.
It’s also wise to keep some money spare in case anything unforeseen happens in your life, instead of using every last cent of your equity on a new loan.
Using equity can be a gamechanger for many, and can help with locking in better interest rates and avoiding lenders’ mortgage insurance, however, the original home you’re taking equity from will now become security for your new investment property loan, which is called ‘cross-collateralisation’.
Speak to Perry Finance today to get expert advice on whether or not using home equity is right for you and how much you can and should borrow.
In the meantime, there’s a few things you can do to build your equity. Firstly, paying extra repayments on your home loan reduces the amount you owe straight away. Secondly, you can use an offset account to save on interest and make your payments go further. And finally, you can renovate your home in any way you can to increase its market value.