First Published April 2008
Equity is a powerful ally, offering investors a golden opportunity to leverage profits from one property into a burgeoning real estate portfolio. But just how do you do it, and what are the risks involved? Robert Projeski, managing director of Australian Mortgage Options, shows you how
Property buyers who have already taken the plunge towards home ownership have a number of options when financing another property or growing their portfolio.
As the value of your property increases, the equity you build becomes a vital resource to help you create long-term wealth and security through investment.
What is equity?
The amount of equity you have in your property is the difference between its value (the net amount you can get for it on the market) and the amount of money you still have owing on it. That is, if your property is worth $500,000 and your outstanding mortgage is $250,000, you have $250,000 of untapped equity.
Note that the equity calculation involves the current value of your home. This is likely to differ from the purchase price of your home, as its value is likely to have increased over the years that you have owned it. You don’t need to have paid off your loan completely for this to occur.
You need to structure your finances in such a way that accessing equity is easy and efficient. If you lock your loan into a long-term fixed rate, for instance, refinancing that loan to access the equity will cost you thousands of dollars in penalty fees and early-exit charges.
Ideally, you should meet with a finance specialist that understands investing, negative gearing and being able to tap into equity, so they can help you organise the most appropriate financial structure for your investment properties.
Make sure you go to a lender that organises an independent valuer, and then gives you access to the valuation, so that the valuation can be used by several lenders. Ideally, your mortgage specialist would instruct a panel valuer.
How do you calculate the amount of equity you can access?
Calculating your available equity is quite simple: you just subtract what is currently owed on your property from its overall value. In our example, you owe $250,000, and your home valuation came in at $500,000. Using a rule of thumb of 80% of the value of the property, borrowing up to 80% of $500,000 gives you a pre-approved equity limit of $400,000. If you subtract the balance outstanding of $250,000 from your pre-approved equity limit of $400,000, you have $150,000 in equity available, which could be used for a deposit and costs on other investment properties.
Borrowing up to 80% of the value keeps you out of the realm of lenders mortgage insurance (LMI). Borrowing more than 80% loan to value ratio (LVR) will cost you LMI which is designed to protect the lender, not you the borrower.
How does it work?
Once you know what the figure would be, you can work out the best way to use that equity. You could buy one investment property, but with our example, you could potentially divide that $150,000 into two sub-accounts and buy two properties. Account number one would be your principal place of residence, the owner-occupied property having a mortgage of $250,000, while two sub-accounts of $75,000 each could fund two new investment properties.
Say you buy an investment unit valued at $300,000, and you borrow up to 80% of the value of that unit. This means you will need a standalone mortgage against the investment unit of $240,000. The difference between the $300,000 purchase price and the $240,000 loan is $60,000, which you can access out of the equity of the owner-occupied property, leaving an additional $15,000 for acquisition costs including stamp duty, legal fees and valuation fees.
What about serviceability?
You don’t need to actually spend any of your own money to acquire an investment property; in our example, all of the costs have been financed through your equity release.
But remember, you will need to make interest repayments on this full amount – both the $60,000 equity release, and the $240,000 mortgage – so your personal financial situation, and your ability to service the loan repayments, will determine how much equity you dip into.
In this example, you still have sub-account number three with $75,000 available to duplicate this process and acquire another investment property, if you are in a financial position to do so.
What about cross collateralisation?
For your investment property, it may be advisable to seek a different lender from the one your owner-occupied property is financed through.
The reason for this is that going to one lender for all of your mortgage transactions might prompt the lender to try to secure its position by cross collateralisation of all your assets/properties in the one mortgage document. Cross collateralisation means that your loan is secured by two or more properties – so your investment loan might be secured by your investment property, and your principal place of residence. This gives the lender greater power. For example, if you decide to sell your investment property, your lender could insist that you use the profits from the sale to pay down your existing home loan. It also complicates your ability to efficiently refinance down the track.
I recommend that you keep every property as a standalone transaction, so that if you eventually want to sell one of your properties, you can do so without it affecting any of your other business transactions or owner-occupied debt.
What are the costs?
After speaking with your current lender and with other mortgage specialists, you may feel that refinancing to access your equity is the right way to go.
Nowadays, refinance costs aren’t as great as they used to be. The main cost component is usually mortgage stamp duty, and this amount varies from state to state – some states have even abolished it. The cost is quite manageable, usually between $500 to $1,500 for loans under $500,000.
Other costs you may need to factor in are valuation fees and costs in relation to preparing the mortgage documentation. These may total approximately $600.
If your loan is currently on a fixed rate, there may be some exit costs incurred in getting out of that loan, or if you have had your loan for only a short period of time with your current lender, there might be early repayment penalty fees. These expenses can range from a few hundred dollars to several thousand dollars.
What are the traps to watch out for?
Using your equity is one of the most cost-effective ways to expand your property portfolio and employ a solid wealth creation strategy.
If you decide to get an equity loan – formerly known as a line of credit – in order to unlock your equity, you need to be very disciplined, as these types of loans can act like a big credit card. If a portion has been allocated for investment debt, make sure that you don’t draw on the money for personal debt and expenses.
This is important for two reasons: firstly, because you don’t want to waste the money that you had set aside for investing; and secondly, because when it comes time to do your tax return, things can get messy in regards to working out what was taken out for personal expenditure and what portion is investment debt. Your accountant may even charge you more if he cannot ascertain how you used this equity with any degree of ease or transparency.
In keeping with any wealth creation strategy, discipline is the key because a sudden influx of funds may tempt you to use your equity in other ways, eg, a new car or an overseas holiday.
If the aim of your loan was for property investment purposes, stick stringently to this path. As with our example, if you are going to turn what was a $250,000 debt into a $400,000 one, you ideally want something to show for it down the track – not just some nice memories of your trip.
Find a good mortgage expert, one who understands you dreams and aspirations for wealth creation, and it will be your first step in being well on your way to achieving those dreams.
Are there any other considerations?
It’s important to make sure that your equity loan is a ‘set and forget’ facility, which means they don’t ask you to provide financial details on a regular basis. Your financial position should only be assessed once, and that is when the loan documentation is processed and application approved.
The other thing to be cautious of is an annual or ongoing package fee, particularly when the documentation says ‘fees and charges may vary’. If it is $300 in fees today, it could be worse down the track.
Ideally, you should speak to a mortgage manager or specialist about your wealth creation strategy, as some banks or loan managers don’t understand lending for investment strategies
. Once you start building a substantial property portfolio, their concerns might prompt a move to cross collateralisation, and this is what you want to avoid.
Every five to seven years, reassess the situation and revalue all your properties, including your owner-occupied and investment properties. Even if you pay interest only on the investment components, as the value of the property increases you can start tapping into the equity from the each property and keep duplicating the process – and this is when you will really see your extensive property portfolio take shape.
In doing so, you could even access equity to free up the loan on your owner-occupied home, so that your home is unencumbered and debt free.
Robert Projeski is managing director of Australian Mortgage Options.
Disclaimer: while due care is taken, the viewpoints expressed by contributors do not necessarily reflect the opinions of Your Investment Property.