Purchasing an investment property with equity is a very common strategy amongst investors. Equity is the difference between the value of the property vs the outstanding loan amount. An investor leverages the difference between these two values to purchase an investment, using this as their deposit.
How to use Equity to buy investment property
Equity is defined in two ways, total equity, and usable equity. A home’s usable equity is 80% of its value, minus the amount outstanding on the loan. Banks do not loan above this 80% as this provides a buffer in the event your home declines in value. In my Buying an Investment Property In Australia post I discuss how I used equity to start my property investing journey.
Take the following example. An investor wishes to purchase a residential property using equity. Their home is worth $500,000 with a remaining home loan amount of $100,000.
In this example the investor has $300,000 available equity (($500,000 x 80%) – $100,000)
Using equity to invest has several tax advantages whether that be applied to property and real estate or shares and ETFs. As you are borrowing to generate an income, the Australian Taxation Office (ATO) have advantageous tax benefits which makes investing appealing. In my posts I discuss these benefits in greater detail when discussing negative gearing and borrowing for Shares and ETFs.
When taking out equity in your home it is important to have this as a separate loan. Some investors make the mistake of using their current offset account or the available owner occupier home loans redraw facility.
Through doing these investors are ‘mixing’ their loans and this requires great effort to undo or lodge an accurate tax return. Therefore, this should be avoided at all costs, and individuals should seek loan structure advice from a qualified broker and accountant.
Equity Investment Home Loans
Equity home loans can be either principal and interest or interest only loans. It is also important to not only look at the interest rate of the loan but also the comparison rate.
The comparison rate of a loan will also factor in all other fees and charges these loans may have. For further information regarding home loan interest rates read Money Smarts Choosing a Home Loan article.
It is important to understand what type of property you are wanting to buy. Banks have different lending criteria which impacts on the loan to value ratio when it comes to investment property loans. It is important to consider a properties overall loan to value ratio.
If an investor needs to borrow more than 80% of a property’s value they will likely pay lenders mortgage insurance (LMI).
LMI is essentially you paying for the banks insurance to lend you money as you are deemed greater risk when borrowing more than 80% of a property’s value.
Understanding what cross-collateralisation is and its implication is very important for investors. Cross-collateralisation is when an investor utilises more than one property as security for a loan. For example, an investor uses their principal place of residence (PPOR) and their new investment property to secure the one loan.
Blue Fox Finance have an excellent explanation of what cross-collateralisation is, complete with visuals.
To avoid cross-collateralisation an investor should look to have an ‘equity split’ which is essentially a second loan. This second loan is their equity which is taken out against their PPOR.
Thus, the investor would end up with 3 loans. These loans would be an owner-occupied loan, equity loan and the investment loan, taken out on the investment property itself. It is important to speak to a broker and accountant to ensure you have the structure that meets your individual needs.
The risk associated with cross-collateralisation is that the investment purchase is secured against your existing home. In the event your circumstances changed, and you were unable to service the debt. The lender could repossess both properties as they are tied together through the loan structure.
It is important to assess your investment objectives and determine the feasibility of utilizing existing equity. Additionally, it is essential to take into account the interest rate associated with investment properties.
There are other means of such as using cash as a deposit for an investment property. Though the overall benefit is than an equity loan when used correctly = for an investment property is tax deductible. *You should seek individual financial advise to ensure your loan structure meets your own personal needs.