Investors regularly talk about using equity to build a property portfolio, but how do you actually get a hold of it? That’s a question Stuart Wemyss sets out to answer as he explains the safest, riskiest and most rewarding ways to refinance
If you can come to terms with using equity to either start out in property investment or make up any negative cash flow applicable to your existing portfolio, how do you actually get hold of your equity?
What practical methods of ‘refinancing or restructuring’ are the safest and what are the pros and cons of using various loan structures to release your equity so it can work for you?
1. Line of credit
There’s no denying that a line of credit can be a handy method to access equity and one that is often recommended to investors as the easiest option. Many lenders and mortgage brokers suggest that lines of credit are beneficial because they provide borrowers with flexibility in terms of availability of funds, transaction capability and loan repayments, all at home loan rates.
It’s true that a line of credit allows investors to withdraw the funds they need up to the agreed limit for a number of purposes, such as to put down a deposit or purchase an investment property at any time when the opportunity arises.
However in my experience, less than 5% of the clients I deal with would benefit from using a line of credit to access their equity. Generally speaking, a line of credit is more expensive than other loans because most lenders charge a higher interest rate for them. There are many other loan products that allow you to access equity without having to pay any interest at all, until you use the money.
This is of great benefit if you intend to use your equity for a deposit on an investment property, as you’ll need to set up the loan facility before you make the purchase.
For this reason particularly, I would suggest that as an alternative to a line of credit, investors should consider a loan with redraw or an interest-only offset. Although a line of credit can be a good option, there are often lower cost products that allow easy access to borrowable equity.
That said, a line of credit is necessary for the negative cash flow funding loan structure discussed above, in order to meet ATO guidelines.
2. Second mortgages
A second mortgage is taken when an investor approaches another lender, with whom they don’t have their initial mortgage, to take out a loan against their home or another property they own. For instance, if you decide you want to access your equity for a deposit on another property, you might approach the Commonwealth Bank when your initial home loan is with Westpac. You’ll therefore end up with two separate mortgages from two separate lenders against the one property (as Westpac already holds the first mortgage, Commonwealth Bank has to register a second mortgage).
This isn’t really a popular option these days and most lenders avoid second mortgages wherever possible. The secondary bank is uncomfortable with this set-up because it knows that the initial mortgagee will be paid out first should anything go wrong and as a result, it will often lend a much lower LVR to obtain a higher security buffer.
Therefore, it’s not an efficient use of equity.
3. Refinancing with the same or new lender
Generally, these days you would refinance with the lender who already holds the mortgage on your home (this is often called an internal refinance or restructure) and establish second account with them (as in the example loan structure), or you’d refinance everything to a new lender and establish two new accounts (often called an external refinance).
This approach has some distinct advantages. Your existing lender can establish a second loan account just by setting up a new loan agreement which means they simply rewrite the existing mortgage contract, or create a totally separate mortgage contract, but they generally don’t need to change the registered mortgage itself because they already have a charge over that property – they’re really just using the equity in it.
They would revalue the property, do the sums to work out how much borrowable equity can be released, then give you access to those funds by establishing a new account (assuming you can afford to borrow the money of course).
When you establish a second account in this manner, you can opt for either a basic variable loan or a loan with an offset facility. The basic variable loan would be fully drawn on the day it’s established and you would then take the money and repay it back into the loan leaving a small portion outstanding (say $20), and redraw this money as required for your deposit. Be careful to check that the loan is a ‘true’ interest-only loan in that repayments are based on the actual balance and not the original limit (as some are).
With an interest-only offset loan you would deposit the loan funds you can access (let’s say $60,000) into the offset account and because the loan is offset by the $60,000 cash, there’s no interest payable until you withdraw the money from the offset to use as a deposit for your next investment.
In both cases, these accounts need to be established prior to making an investment property purchase so that you can access the necessary deposit from your equity. It is likely that both these options will turn out to be cheaper than a line of credit.
Any secondary accounts you establish are the direct result of refinancing your existing mortgage. As we said earlier, you have two options when you refinance to gain borrowable equity; either an internal refinance from your own lender or an external refinance from another lender.
An internal refinance simply involves approaching your existing lender and restructuring your loan(s), by varying your existing loan contract. The bank will conduct a valuation on your property and tell you how much you’re able to access, then establish a second account. The beauty of establishing a second account, as opposed to increasing the size of your existing loan, is that you can maintain some distinction between the purpose of the debts (very important). Remember, you don’t want to get your non-deductible debt mixed up with your tax-deductible debt – the paperwork nightmare this creates is horrifying!
When you engage a new lender to do an external refinance, they have to do a valuation on your existing property, then contact the incumbent lender, arrange to pay them out and take over the existing mortgage as well as establish a new account for your borrowable equity.
There’s a negative and positive aspect to taking the approach of starting over with a new lender. On the downside, it can take a lot longer than an internal refinance and could be more costly (i.e. there could be discharge fees). However, if you want to access your equity to make further investments, the bank’s valuation becomes critical, so using an external refinance can provide a clean slate and potentially a more favourable outcome with the valuation process.
For instance, if valuation issues arise with your existing bank, let’s say they use a very conservative valuer in your area, it can pay (literally) to approach a completely different lender who uses a different valuer. As well as this, you might be restricted by your current lender’s valuation policy, in that some lenders will only conduct revaluations every twelve months, so external refinancing is a way to get around that.