How does equity work when buying a second home

How does equity work when buying a second home
If you're thinking about how to finance a second property, did you know you can unlock your existing home equity to do so?
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What is equity in your home?

The equity in an asset is its value, less any money owed on it.

For example, if your house is valued at $600,000 and the current debt is $250,000, the equity in the home would be $350,000.

Using equity : How does equity work?

Accessing the equity in your loan is easy. With a simple mortgage refinance, you can be steps closer to buying a second home. Using equity in an investment property to buy a home works pretty much the same too. The equity from your home or investment property can be used as a deposit on a second property, while your current property becomes a security on the new debt. Using equity allows you to buy a second property with no cash deposit.

When the value of your home rises, the equity does too. A home's value may rise because of capital growth or dedicated mortgage payments. You could also increase the value in your home by making renovations (though you will need to consider the costs of materials and labour to do this).

Your lender will calculate your loan to value ratio (LVR) to ensure some equity is held as security. After this, you can determine how much equity you have after refinancing.

Consider the earlier example, where the equity is $350,000.

If your lender offers an 80 per cent LVR - note than anything higher than this will likely require Lenders Mortgage Insurance - you have $230,000 usable equity. This amount can be used for a home mortgage for another property. Keep in mind that you'll need more than the deposit - stamp duty and legal fees will have to be factored in.

Not sure how much equity you have in your home? Use our home equity calculator to find out.

Calculate your equity

Line of credit or lump sum

A line of credit loan means a certain credit amount is approved based on your usable equity.

You only pay interest on what you spend. You can apply for an equity release, but if you’re not ready to use the funds right now, ensure you have an offset sub-account so you won’t pay interest on the loan increase until you use the funds.

If you take out a lump sum, you'll pay interest on the entire amount. With a line of credit, you only pay interest on the amount used, but you could be tempted to access this money for unnecessary luxuries.

Should you cross collaterise?

According to loans.com.au Product Manager Tiska Sudarmana, cross collaterisation has its risk but can provide certain benefits under the right circumstances, such as minimised fees.

The equity of your current property is used as security for loans on both this property and another property. So if you can't pay off the debt on one property, then both properties could be repossessed.

However, there are some cases that permit cross collaterisation. For example, the debt on your current property might be too high to allow traditional refinancing.

If you will be able to pay off both mortgages and perhaps have good knowledge of the property market, then this could be an option - but be aware of the risks.

Risks

As with any investment, it pays to be aware of the risks.

If you are buying a second property, you are not diversifying your assets - you are instead concentrating your wealth. If the property market drops, so will the value of your home. Of course, if the market works in your favour, you could do very well.

Consider how much knowledge you have of property investment in general, as well as of the particular market you are looking to buy into, and consult a financial adviser if you're unsure. It may also help in the long run if you have the cheapest investment home loan in the market. You’ll save more money by not paying too much interest. Take the time to research and compare home loan rates to find the best one for you.

Can you use equity to buy a house with no deposit?

Utilising the equity in your current property can allow you to buy that second property with no deposit by using a tactic called leveraging.

Leveraging is where you use the equity generated by the rising value of your existing property to purchase a new one. This strategy depends on the value of your existing property rising while the size of the mortgage either reduces or stays the same.

Here’s how that works:

  • You buy a property for $400,000 and put down a 20% deposit ($80,000), and borrow the remaining 80% ($320,000).

  • Over time the property rises in value by $100,000, meaning the 80% mortgage is now only 64% of the value of the property.

  • You could refinance your mortgage and increase your home loan up to 80% of $500,000 creating a cash pool of $80,000 which you can use as a deposit for a second property.

If you use the equity as a deposit on a second property, you will be paying off two home loans instead of one, so it’s important to ensure your cash flow will be able to handle this. Refinancing your current property to release equity also means you’re increasing the amount of debt on your current home loan, so you will be paying it off for longer and paying more in interest over the life of the loan.

How much equity do you need to buy another home?

Lenders will typically allow you to borrow up to 80% of the equity in your property, minus outstanding debt, to purchase a second property.

For example, Kellie buys a property worth $500,000 with a 20% deposit ($100,000) and a $400,000 home loan. At this point her equity in the property is $100,000.

Over 10 years, she pays $150,000 off the home loan’s principal (leaving $250,000 owing) and the property’s value increases to $550,000. Her equity in the house is now $300,000.

She wants to access some of her $300,000 home equity to use as a deposit on her next property. She’ll need to put down a 20% deposit on the new property, leaving her with 80% LVR. In Kellie’s case, 80% of her property’s value ($550,000) is $440,000. Take away her outstanding debt of $250,000 and she’s left with her possible available equity of $190,000.

While her equity might be $300,000, her available equity is actually $190,000.

Advantages of using equity to buy another home

Many investors use equity in their existing properties to purchase more investment properties, which enables them to build a bigger investment portfolio. By using existing equity to buy more properties, you can get into the market at today's prices and reap the rewards of price growth than if you had waited and saved the deposit, which can take years.

Using equity to buy an investment property

Equity is one of the most powerful tools property investors have at their disposal because it allows them to build their property empire faster. As mentioned above, lots of investors use the equity in their current property to buy another investment property. That property then grows in value allowing the investor to buy another investment property, and so on.

Over time, if you keep using this approach and adding even more properties to your investment portfolio, it will have a compounding effect: every time the property market rises, your property wealth and useable equity will rise too. On the other hand, if the property market falls, your wealth and useable equity falls too.

Using Equity FAQs 

How does using equity to refinance affect my current loan term?

Refinancing your current home to access equity is essentially increasing the debt on your current home loan, so this often means that you are taking the loan with a higher loan term than what’s left of your original loan.

How does accessing equity affect your loan repayments

Accessing your equity can increase how much you owe as well as the interest charged which  means your home loan repayments will likely increase.

Can you buy a second house and rent the first?

Yes, you can buy a second house and rent out your first as an investment property. But there are a few key things to consider such as potential tax implications. 

It’s important to make sure the numbers stack up, for example does the property pass the six year rule? You can rent out your primary place of residence for up to six years and keep its capital gains tax (CGT) free status.

After six years, the Australian Taxation Office (ATO) will treat your home as as investment property meaning it will be liable for CGT if you sell.

Tags: equity in home | home loans

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