Do you have your eyes set on a property investment opportunity but you’re struggling with your finances? Saving for a down-payment can be a major hassle for many. However, ask any property guru and you’ll find that the key is to access your home equity.
To help you understand the ins and outs of how to buy a investment property using equity, we’ve put together this brief guide. We’ll start off with the basics.
What Is Home Equity?
Home equity is the balance between the current value of your home and how much you owe on it. For example, if your house has a market value of $500,000 and the current debt is $200,000, your equity would be $300,000.
Using equity to invest is as a great financial strategy. Homeowners can use it to cover renovation expenses, to extend their property, to start a business or any other use the bank approves for the loan. However, home equity is mostly used to buy an investment property.
Is the Full Amount of Your Home’s Market Value Usable?
Unfortunately, the answer is no. Banks don’t take high risks and will not approve you to use the entire value of your home. That’s because if house prices fall, banks don’t want the outstanding loan to exceed their clients’ asset.
The usable equity is 80% of your home’s value minus any amount you owe to the bank. So, if your home is worth $500,000, the usable equity would be $400,000 minus the $200,000 debt, which brings you to a $200,000 value of usable equity.
To calculate your home equity, the lender will send a property appraiser, but the amount they report may not match the value you think your house is worth.
Nonetheless, your property’s value will increase as you settle your mortgage and as the market value rises. Bear in mind that market fluctuations have a great impact over your home’s equity value. Negative capital growth will considerably affect your home’s equity even if you’re up-to-date with your mortgage payments.
One way to beat negative capital growth is by adding value to your property through renovations, extensions, or separate construction. You can maintain the current value of your property even if the market plunges.
What Loan Will the Bank Approve Against Your Home Equity?
The best way to calculate the loan value which you can borrow for your investment property by using home equity is by multiplying the usable equity by four. So, as in the case above, if you’re usable equity is $200,000 it means the maximum purchase price you should consider for an investment property is $800,000.
The bank will offer a credit line against the future property. So, in the case above, banks will offer 80%, or $640,000. The difference up to the investment property’s total value of $800,000, meaning $160,000, will be covered by your deposit. You should also set aside about 5% for extra costs (stamp duties, notary services etc.)
What Type of Loan Should You Request from Your Bank? a Line of Credit or a Lump Sum?
You have a few options in terms of the type of loan you can take from your bank. You can either opt for a line of credit or a lump sum. A line of credit functions on the same principle as a credit card, meaning that you will only pay interest on what you spend. Conversely, with a lump sum, you’ll be paying interest on the full amount, regardless of how much you use. In both cases, the amount of the loan will depend on your usable home equity, among other factors. And they both have benefits and drawbacks.
With a line of credit, if you don’t need to use the whole amount, you will pay less overall interest. However, the interest rate tends to be higher because of the flexibility. With lump-sum loans, you will get a lower interest rate but if you don’t need to use the whole amount, you’ll be paying higher interest costs.
The type of loan you choose will first depend on how you will use the money. For example, if you’ve already identified an investment property you wish to purchase and will be using your home equity to fund the down payment, then you’re probably better off with a lump sum to keep interest costs as low as possible.
On the other hand, if you just want the money to be available for when you find an investment property, then a line of credit is your best bet so you don’t have to make payments on money that’s just sitting there.
Of course, how much you can afford to repay every month will also be a factor. Remember, closing on a property takes time, and it will take even more time before it’s producing any rent, especially if you need to fix it up. So, you have to think about how much you can afford in terms of monthly investment loan repayments, which will be coming out of your pocket for at least a few months. This repayment calculator will help you figure out how much you can expect to pay for different loan amounts, so you can work out how much you can afford to borrow and what loan type is your best option.
Should You Consider Cross Collateralization?
If you’re thinking about cross-collateralization, you could be taking on a high risk. If you can’t pay off the debt on your current property used as security for the two loans you have, then the bank can repossess both properties.
However, if the value of the mortgage you have on your current property is too high and you can’t access traditional refinancing, then you should consider cross-collateralization.
Also, if you’re confident that you have enough insights into the property market, and you can cover both mortgages, then cross collateralization could be a viable decision.
Calculate, Calculate, Calculate!
Before you set off to developing your property portfolio, make sure you plan your budget wisely. Include a buffer fund for various expenses, such as sudden rises in interest rates, repairs, any rent vacancy periods etc.
Now that you know the details about buying an investment property using equity from home, you’re ready to strategize and apply correct risk safety measures to make the best decisions.