How to: Use your equity to buy your next property
Investors looking to build a portfolio and hold their current property, or their home, are constantly looking for ways to jump into the next opportunity. While selling one property and pouring the funds into another can be a possibility, those wanting to build a portfolio may see themselves benefiting from holding on to their purchases - particularly when a significant amount of growth has been seen over a long period of time, or when the prospects for the property are favourable.
When property prices rise, as we have recently been seeing them do around the country, it’s only natural that investors will start wondering whether it’s enough to leverage them into investment number two. This is known as using your home's equity (or your property's equity) and pouring it into another purchase. You may also see this regularly referred to in investment circles as "tipping" equity into another property or "pulling" equity.
A number of experts, including those that write for Property Observer, such as Cameron McEvoy, have used this technique to build their property portfolio and their initial wealth.
Pulling equity allows you to hold onto an asset that may still grow, avoid exit costs and free up funds that may otherwise cause you to miss an opportunity. However, it does mean that you're looking at holding on to a substantial amount of debt - a concept you will need to become comfortable with should you be looking at holding multiple properties.
But where do you start?
To begin, you need to know how much equity you have available - a quick back of the envelope calculation will help you figure out if it’s even going to be viable enough to begin speaking to your lender.
This comes down to two different factors:
The property’s value – You can work this out through a number of different options. Online valuations, calling local experts such as real estate agents, checking out online comparables or getting a valuation undertaken, can all give you a rough guide. Have a read of this Property Valuation 101 guide to give you a leg up when undertaking this part of the process.
How much you owe – Check your statement for what the balance looks like on your mortgage.
The equity you have iis the balance left when you take away what you owe from the value of the property. Let’s assume the property value is now $400,000, and your balance owing is $200,000. This leaves you $200,000 worth of equity.
If you don’t have a substantial amount of equity remaining, you will want to try and push one of the two equations more favourably by either paying down your mortgage more quickly, or by increasing the value of the home. Hopefully, if you've been selective about the area of purchase, you will have seen some capital growth that will have increased the equity without you needing to lift a finger. Those that haven't been so lucky will need to look towards these other value adding measures.
There are a number of guides for doing both of these things. Here are 25 tips from Yellow Brick Road on paying your mortgage off faster, and a number of ways to add value to your home (either through renovations, additions or other improvements).
How much equity can you pull out?
You cannot just tip the entire $200,000 into another property, as this will leave your “owing” balance at 100% on the current property. You also want to ensure that you have enough equity as a buffer in case you see any downturns in value – you do not want to be left with negative equity in any situation (where you owe more than the property is worth).
"If you don’t have any spare funds aside from the equity in your home, then do not use all your usable equity to invest in property, just in case you need to draw on it in the event of an emergency. Even if it means you can’t invest for a while, it is always important to keep yourself protected," NAB warns in their guide to using equity.
With this in mind, you then need to look at how much to leave in the current property for when you refinance. Leaving 20% of the property’s current value (or $80,000), provides you with $120,000 of equity available to play with.
You may be able to use $80,000 of the equity to move into another $400,000 investment property. The back of the envelope calculation in this situation stacks up. Note: Don’t forget that if you want to borrow the amount for the costs as well, this may further erode the amount of equity you have to play with.
Refinancing, cross-collateralisation and finance
To release the equity, a lender will send around a valuer for a new bank valuation. This may be different to your own calculations and will determine the amount you have available in their eyes.
You’ll be looking to refinance your property so that you can have a new mortgage, with a new LVR. Firstly, read our free eBook guide on refinancing.
We also have a freely available webinar presentation on the ‘Dos and Don’ts’ of refinancing with chief executive of the Mortgage and Finance Association of Australia, Phil Naylor.
By this point, you’ll likely have heard the term cross-collateralisation, as well as the associated warnings that many will provide you about this type of structure. Certainly, it isn’t for everyone; however there are some significant benefits to this type of loan.
Cross-collateralising, or where you use one property’s equity as security for another, rather than taking out a separate loan, has certain benefits. Investors Choice Mortgages’ Jane Slack-Smith explains that one of the upsides is that you do not have to pay mortgage insurance, and that it allows you to get in when, for any number of reasons, you may not be able to achieve a second loan.
However, it does make it more difficult to leave the lender in the future, and can leave your properties “tied” to one another so that if your entire portfolio stays stagnant as a whole, yet one property has increased in value, you may see yourself unable to release the equity in the future.
You can read Slack-Smith’s thoughts on how you should be structuring your finances when using your equity in this how to article.
When it comes to borrowing for the next investment, you need to be aware of your borrowing capacity. The same concerns for when you took out your initial mortgage still apply. While this varies from person to person, a generally rule of thumb provided by NAB is to multiply your available equity by four.
Finally, remember that equity can be used for a number of different things. You may want to consider tapping into your equity to fund renovations, new builds or even fund your retirement. Some are more comfortable just paying down one property and aiming for a debt-free asset, rather than using any growth to jump into another property.
How, when and if you grow your portfolio is, ultimately, up to you as an investor.
Are you looking to release equity?