Investing in a second property is a significant financial move, and leveraging your home equity can make this goal more attainable. The gap between your property’s current market value and the remaining mortgage balance is known as equity. This untapped resource can be a powerful tool to fund your next real estate investment. In this blog, we will explore how to use equity to buy a second property, the benefits, and the steps involved in the process.
Understanding Equity and Its Uses
Equity builds over time as you pay down your mortgage and as your property’s market value appreciates. When you have sufficient equity, you can borrow against it to finance a second property. This process involves using your home as collateral for a new loan, which can be a home equity loan, a line of credit (HELOC), or refinancing your current mortgage.
Benefits of Using Equity to Buy a Second Property
Using equity to purchase a second property offers several benefits:
- Access to Low-Cost Financing: Home equity loans and credit lines typically provide more favourable terms than other loan options, especially with regard to interest rates.
- Potential for Investment Returns: Investing in real estate can generate rental income and property appreciation over time.
- Diversification of Assets: Owning multiple properties can diversify your investment portfolio, reducing overall risk.
Steps to Use Equity for Buying a Second Property
- Evaluate Your Equity: Calculate the amount of equity in your current property. Lenders typically expect homeowners to maintain a minimum of 20% equity.
- Determine Borrowing Power: Calculate how much you can borrow against your equity. Generally, lenders permit borrowing up to 80% of the appraised value of your home after subtracting your remaining mortgage balance.
- Choose the Right Loan: Consider a home equity loan, HELOC, or refinancing. Each option has its own advantages and disadvantages depending on your goals and financial situation.
- Apply for the Loan: Submit an application to your lender, providing necessary documentation such as proof of income, property value, and existing debts.
- Purchase the Property: Once approved, use the funds to buy your second property, ensuring you fulfil all necessary legal and financial requirements before completing the transaction.
Additional Considerations
Using the “Rule of Four”
A simple rule of thumb when buying an investment property is to multiply your usable equity by four to determine the maximum purchase price. For example, if you have $100,000 in equity, the highest purchase price for an investment property would be $400,000.
How Equity Works in Australian Property
Equity in Australian property is calculated as the difference between your property’s market value and your outstanding mortgage balance. This equity serves as collateral for loans for additional property investments. Here’s how it works in detail:
- Market Value and Mortgage Balance: For example, if your property is worth $800,000 and your mortgage balance is $400,000, your equity is $400,000.
- Using Equity as Collateral: Lenders often allow borrowing up to 80% of your property’s appraised value. Thus, in this case, you could potentially borrow $240,000 (which is 80% of $800,000 minus the $400,000 mortgage balance).
Why Use Equity to Buy a Second Property?
Using equity to buy a second property allows you to leverage your existing investment to grow your real estate portfolio, leading to increased rental income and potential capital gains. Additionally, leveraging equity can provide:
- Tax Benefits: Interest on loans used for investment properties may be tax-deductible.
- Investment Growth: Real estate often appreciates over time, potentially increasing your overall net worth.
- Improved Cash Flow: Rental income from the second property can help cover the mortgage payments and other expenses.
How Equity Functions When Purchasing a Second Home
When buying a second home, the equity from your current property can serve as a deposit on the new property. Your existing property becomes security for the new loan, allowing you to purchase without needing a cash deposit.
Is It Possible to Buy a Second House and Rent the First One?
Yes, you can buy a second house and rent out the first one. This approach enables you to earn rental income from your first property while living in your second property.
How to Keep Your Old Home as an Investment and Rent It Out?
To keep your old home as an investment, you need to:
- Inform Your Lender: Notify your lender about the change in property use from residential to investment.
- Adjust Mortgage Terms: You may need to adjust your mortgage terms to reflect the rental income, which might affect your interest rate and repayment schedule.
- Property Management: Think about hiring a property management company to handle tenants, maintenance, and other property-related tasks.
Can We Afford a Second Property?
Affording a second property depends on your financial stability, including your income, expenses, and existing debt. Here are steps to determine affordability:
- Detailed Budget: Prepare a detailed budget that accounts for all potential income and expenses related to the second property.
- Financial Analysis: Carry out a detailed financial analysis to understand your borrowing capacity and its impact on your cash flow.
- Professional Advice: Consult with a financial advisor to assess your financial status and ability to manage additional debt.
Am I Required to Pay Mortgage Insurance?
If your equity in the new property is less than 20%, you might be required to pay Lenders Mortgage Insurance (LMI). This insurance protects the lender in case you fail to repay the loan. Here’s how it works:
- LMI Cost: The cost of LMI varies based on factors such as the loan amount and the loan-to-value ratio (LVR). It can be a substantial expense, so it’s crucial to include this in your budget planning.
- Avoiding LMI: To avoid LMI, ensure that you have at least 20% equity in the new property or a larger deposit.
How to Create Home Equity Faster
Get a Second (or Third) Valuation
Different banks may appraise your property at different values due to varying assessment criteria. Obtaining multiple valuations can sometimes increase your usable equity. Here’s how to make the most of it:
- Shop Around: Approach several banks or independent appraisers to get a range of property valuations.
- Compare Criteria: Understand the criteria each appraiser uses, which may include recent sales data, property condition, and location-specific factors.
- Negotiate Better Terms: Use higher valuations to negotiate better loan terms or to access more funds.
Have a Bigger Deposit
A bigger deposit can lower your loan amount and build equity faster. Here’s why:
- Lower Loan-to-Value Ratio (LVR): A bigger deposit means borrowing less, leading to a lower LVR, which can result in better interest rates.
- Reduced Interest Costs: With a smaller loan amount, you pay less in interest over the loan term.
- Financial Security: A larger deposit provides a buffer against market fluctuations, reducing the risk of negative equity.
Get a Shorter Loan Term
Shorter loan terms usually come with higher monthly payments but can save on interest and build equity more quickly:
- Interest Savings: Shorter loan terms mean fewer interest payments over time, significantly reducing the total cost of the loan.
- Faster Equity Growth: Higher monthly payments contribute more towards the principal, accelerating equity buildup.
- Financial Discipline: Committing to higher payments encourages disciplined financial management and quicker debt repayment.
Make Extra Repayments
Additional repayments towards your mortgage can significantly reduce the principal amount and build equity faster:
- Principal Reduction: Extra payments directly reduce the principal, which lowers the interest charged on subsequent payments.
- Flexibility: Making extra payments when you have surplus funds can shorten the loan term and reduce total interest paid.
- Lump Sum Payments: Utilise features like redraw facilities to make additional payments without penalties and access funds if needed.
Use Lump Sums and Windfalls
Additional income, like bonuses or tax refunds, can be used to make lump sum payments towards your mortgage:
- Direct Impact: Lump sums directly reduce the principal balance, accelerating the rate at which equity is built.
- Interest Savings: Reducing the principal early in the loan term can lead to substantial interest savings over the life of the mortgage.
- Financial Gains: Reinvest windfalls wisely by reducing debt, which can improve your overall financial position and creditworthiness.
Use One Partner’s Income
If possible, use one partner’s income for living expenses and the other partner’s income for mortgage repayments:
- Accelerated Repayment: Dedicating an entire income stream to mortgage repayments can significantly shorten the loan term.
- Budget Management: This approach enforces a strict budget, ensuring that living expenses are kept within one income while the other boosts equity.
- Financial Resilience: By having one income cover all living expenses, the household can better manage financial pressures and build a strong equity position more rapidly.
Case Study: Leveraging Equity for Investment
Consider John and Lisa, a couple who purchased their home five years ago for $500,000. Their home is now valued at $700,000, and they have $300,000 remaining on their mortgage. This gives them $400,000 in equity. Using the “rule of four,” they determine they can afford an investment property worth up to $1,600,000. They decided to use a portion of their equity to purchase a second property valued at $600,000. By refinancing their current mortgage and securing a home equity loan, they are able to finance the new property without needing a cash deposit. The rental income from the second property covers the additional mortgage payments, and over time, both properties appreciate in value, enhancing their overall investment portfolio.
Using equity to buy a second property can be a strategic move for growing your real estate portfolio. By understanding the process, evaluating your financial stability, and considering market conditions, you can make informed decisions that align with your investment goals. Always seek professional advice to ensure that leveraging your equity is the right choice for your financial future.
Ready to leverage your equity for a second property? Contact us today to explore your options and make informed investment decisions!
