Using equity to invest in property

Written by view.com.au in Investing

Piles of coins

Using equity to invest in property has become one of the most common ways in which to make that leap from being a home owner to a property investor. It is an effective way to open yourself up to further investment, but it must be done responsibly and with a full knowledge of your own budget as well as local and national markets. Investing in property when still paying off a mortgage on your home opens yourself up to market forces, and entails a level of risk regardless of how well you prepare.

How to calculate the equity in your home.

The equity in your home is essentially the difference in the value of your home and your outstanding mortgage debt, what you are yet to pay off. So, calculating the equity in your home is simple. If you have a $600,000 mortgage and the value of your home is $900,000, then the equity in your home is $300,000.

However, banks will rarely let you borrow on more than 80 per cent of your equity (unless you take out lenders mortgage insurance). Because of this, you then need to calculate 80 per cent of the value of the home (.8 x $900,000 = $720,000) and then deduct your outstanding mortgage from that figure ($720,000 – $600,000 = $120,000). The equity you can realistically borrow from is therefore not $300,000 but $120,000.

You then have $120,000 to put towards the deposit and extra costs of an investment property.

The pros and cons of using equity to invest in property

PRO

  • Using equity to invest in property can be an effective way to reach financial goals sooner, compounding capital growth in more than one asset.
  • In a strong market, you have the opportunity to monopolise on the capital growth of your home without having to sell it.
  • Interest attributable to the investment property is tax-deductible.
  • You have the option to refinance your existing mortgage as well, however this may not suit some budgets and must be done with a full knowledge of the risks.
  • As long as risks are considered, both the security and serviceability of the loan is assured, and an investor’s budget is not spread too thin, investing in property with equity is one of the safer forms of ‘speculative’ investment.
  • Equity can be used in other investment classes, such as stocks and term deposits. There is a reason for the adage to not have your eggs all in one basket.

CON

  • Inexperienced investors can be lulled into a false sense of security and create property portfolios too quickly with their compounding equity. This places them in an extremely precarious position in relation to fluctuations in the market and their own job security.
  • Redrawing funds on your existing home loan may ‘compromise’ the loan so that it becomes a mixed-purpose loan. Calculating the tax-deductible interest on that can be complicated and expensive. For this reason, it is a good idea to use an offset account to service your home loan from the very start, so that you can separate your loans and pay tax on them separately.
  • A lender will usually allow you to include rental income into the ‘serviceability’ (your ability to pay) of the loan. However, they may reduce this amount by sometimes 25 per cent to account for periods without rental income as well as maintenance costs. You need to be aware of this when assessing your ability to pay off the loan before applying.
  • While using equity to invest in property is a great way to accelerate your financial goals, this should not be at the cost of your cash flow. Some novice investors may spread themselves too thin with their finances when using equity, leaving them susceptible to the four main risks of investing: investment income risk (lower than expected and interrupted rental yield), interest rate risks (rises in RBA interest rates), income risks (changes to your personal income), capital risk (effects of the market on the value of your investments and your home).

There are clear benefits and risks of using equity to invest in property, but it remains one of the most popular and effective ways to build long term personal wealth if done properly and carefully. Understanding your limits, and then investing below these limits, is the only way to cushion yourself from the various economic risks associated with investing.