Have you dreamed of buying an investment property, but don’t have a cash deposit? Don’t give up your dream! If you already own a home, the equity in your property could provide the key to launching your investment property portfolio.
What is equity? In short, it’s how much money you have tied up in your home: the difference between its value and your remaining mortgage.
For example, if your home is valued at $800,000, and you have $200,000 remaining on your mortgage, your equity in the property is $600,000. This is a sum that you can use against a mortgage on an investment property.
However, before you rush in, it’s essential to understand the difference between equity and useable equity – as, generally, you can’t borrow against your total equity. Also you need to understand that borrowing against your home to invest comes with inherent risks.
Calculating useable equity for an investment property
When you apply to borrow money from a bank or other financial institution, they look at several factors. One is the loan-to-value ratio (LVR) in relation to the property. This is the percentage of the property’s value you want to borrow.
In the example above, the LVR is 25%: $200,000 is 25% of $800,000
Traditionally, a bank will lend up to 80% LVR on the value of your property minus the debt owing, provided it thinks you can meet the repayments. In our example above, the breakdown would be:
— Property value: $800,000
— 80% LVR: $640,000
— Debt owing: $200,000
— An LVR of 80%, minus the debt owing, equals $440,000 of useable equity.
Once you know how much useable equity you have, you can roughly calculate the purchase price you can consider for an investment property. A general rule of thumb is between three and four times your useable equity. But, of course, the amount a bank is willing to lend a customer varies on their individual circumstances.
A bank will analyse the ability of any would-be borrower to pay back the debt. It will look at an applicant’s income and their other financial obligations, such as credit cards, car loans, and other mortgages.
The lending criteria of banks also vary according to the state of the market and each institution’s internal risk assessment policies.
Boosting the equity in your home
If you want to boost the equity of your property, there are ways of increasing its market value. Typically, these involve adding value with renovations or landscaping.
Another way to increase your equity is to reduce the amount of debt on your property by paying it down as quickly as you can. Current interest rates are low, so it’s a great time to pay off as much of your home loan debt as possible.
As house prices continue climbing steadily upwards, home owners’ equity levels rise too. If you continue paying down your mortgage as your house increases in value, your equity will continue to grow.
However, the property market can be volatile, and house prices and demand for rentals can rise and fall in different areas at different times. So it’s essential to always do your research before making any investment, and to seek the advice of a financial expert.
Key considerations before purchasing an investment property
Before you choose to expand your property portfolio, make sure you have your finances in order. This includes asking yourself a number of questions to determine your maximum purchase price, and how much you’ll need in rental income to make the investment sustainable.
For example, ask yourself:
- What is the average rental yield for homes in the area I am looking to buy?
- If I need to drop the rent, will the rent still service the loan?
- When property is in high demand, what is the highest amount of rent I can achieve?
- If a tenant (commercial or residential) stops paying the rent or leaves at the end of their tenancy, can I afford to make the mortgage repayments while I try to find a new tenant?
- Can I cover the costs of maintaining the rental property, rates, upkeep, etc
In good times, when capital gains are flowing and demand for rental properties is high, investing in property seems a safe bet. But no investment is risk free and it’s definitely not an investment to be made for quick, short-term gains.
Indeed, the bright-line property rule means that if you sell a residential property you have owned for less than five years you may have to pay income tax.
However, if you work through your finances, and do your research, investing in property remains a smart way to build a solid financial future on the existing equity in your home.
Buying an investment property? Canstar can help!
Whether you’re in the property market for an investment property, a first home, or are up- or down-sizing, if you need a mortgage, you need to talk to the experts. This includes lawyers, real estate agents and a mortgage lender. For the latter, let Canstar be your guide.
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