Using equity as a deposit for an investment property is a strategic approach that can open up numerous financial opportunities for Australian homeowners.
In this guide, we will take you through the process of using your home equity as a deposit to purchase your investment property.
You’ll learn how to calculate your usable equity, weigh up the pros and cons of this approach, and follow the steps to successfully execute this strategy.
Whether you are a first-time investor or looking to expand your portfolio, understanding how to leverage equity can give you the crucial boost you need to get started building your rental property portfolio.
What is Equity, and How Can You Calculate Usable Equity?
Before we dive into the details, let’s understand what equity is and how to calculate your usable equity. Equity is the difference between the market value of your property and the outstanding debt on your home loan.Â
For example, if your property’s value is $500,000 and you owe $320,000 on your mortgage, your equity would be $180,000.
To calculate your usable equity, you need to consider that most lenders allow you to borrow up to 80% of your home’s current value ( Without LMI).Â
Here’s a simple calculation to determine your usable equity:
- Calculate 80% of your home’s value: $500,000 x 80% = $400,000
- Subtract your current outstanding debt: $400,000 – $320,000 = $80,000
So, in this example, you would have $80,000 of usable equity to put towards a deposit for an investment property.
The Benefits of Using Equity as a Deposit for a Property Investment
Using equity as a deposit offers several advantages for property investors. Let’s explore the benefits of this financing strategy:
1. Access to a Large Amount of Cash
Leveraging your home equity can give you a significant amount of cash to use as a deposit for your investment property. This can be particularly beneficial if you don’t have substantial savings or want to preserve your cash for other purposes.
2. Fixed Interest Rates and Repayment Terms
When you use equity as a deposit, typically you will choose a home equity loan). Typically this loan offers fixed or variable interest rates, providing you with the certainty of consistent monthly payments over the loan term.
Depending on your financial goals and circumstances, you can select from various repayment terms, ranging from five to 30 years. If you’re looking for even more flexibility, you may also consider an interest-only loan as part of your financial strategy.
3. Avoiding Lenders’ Mortgage Insurance (LMI)
Unlike traditional investment property loans, using home equity as a deposit may allow you to avoid paying Lenders’ Mortgage Insurance (LMI).
LMI is usually required when you have a deposit of less than 20% of the property’s purchase price. By leveraging your home equity, you can potentially secure a loan with a 20% deposit, eliminating the need for LMI.
4. Easier Qualification Process
Compared to obtaining a separate investment loan, using equity to buy your second property can be an easier qualification process.
Lenders generally perceive this strategy as less risky, as your existing property serves as collateral. Thus, you may have a higher chance of approval and pay interest rates lower than traditional investment loans.
5. Preservation of Other Assets
Using accessible equity allows you to preserve your other assets, such as savings, emergency funds, managed funds, or retirement accounts.
Instead of depleting these resources, you can leverage the equity in your home, keeping your financial safety nets intact.
Considerations and Potential Risks
While accessing equity as a deposit can be an attractive financing option, consider the potential risks and challenges involved. Here are some key considerations:
1. Increased Financial Obligations
Using equity as a deposit means taking on additional debts in the form of a home equity loan. This translates to an extra monthly payment on top of your existing mortgage.
Before proceeding, assess your financial position and ensure that you can comfortably manage the increased financial obligations.
2. Risk of Foreclosure
When you use your home as collateral for the equity loan, you expose yourself to the risk of foreclosure if you fail to meet the monthly payments.
It’s crucial to carefully consider your ability to make both mortgage and equity loan repayments before committing to this financing strategy.
3. Potential Negative Equity
In a declining property market, there is a risk of negative equity. If the value of your property decreases, you may end up owing more on your mortgage and equity loan than the property’s market value.
Assess the market conditions and consider the potential impact on the value of your investment property before proceeding.
4. Additional Costs and Fees
When using equity as your cash deposit, you will incur costs and fees associated with the loan process. These may include application fees, legal fees, valuation fees, and potential ongoing fees for maintaining a loan . Factor in these costs when evaluating the overall affordability of the investment property.
Steps to Use Equity as a Deposit for an Investment Property
Now that you understand the benefits and risks of using equity as a deposit, let’s explore the steps involved in leveraging your home equity to buy an investment property:
1. Assess Your Financial Situation
Before proceeding, assess your personal circumstances to ensure you can comfortably manage the increased financial obligations. Consider factors such as your income stability, current debt, and future financial goals.
2. Calculate Your Borrowing Power
Determine your borrowing power by considering your usable equity, your ability to make home loan repayments, and your lender’s criteria. This assessment will help you determine the maximum purchase price you can afford for your investment property.
3. Seek Professional Advice
Consult with a financial adviser or mortgage broker specialising in investment property financing. They can provide personalised guidance based on your specific circumstances and help you navigate the complex process of using equity built as a deposit.
4. Research the Property Market
Conduct thorough research on the property market to identify potential investment opportunities. Consider location, rental demand, potential rental income, and future growth prospects.
5. Choose the Right Loan Product
Select the most suitable loan product for your investment property purchase. You can choose between a home equity loan or a HELOC based on your preferences and financial goals. Consider the interest rates, repayment terms, and associated fees before deciding.
6. Apply for Financing
Complete the loan application process, providing all necessary documentation and financial information. Be prepared to give details about your current property, income, employment history, and any existing debts.
7. Conduct Due Diligence
Before finalising the purchase, conduct thorough due diligence on the investment property. This may include property inspections, obtaining building and pest reports, and reviewing the rental history and potential rental income.
8. Settle the Purchase
Once they approve your loan, proceed with settling the investment property purchase. Coordinate with your conveyancer or solicitor to ensure a smooth settlement process.
9. Manage Your Investment Property
After the purchase, effectively manage your investment property to maximise its potential returns. Consider engaging a property manager or educating yourself on property management best practices.
Key Takeaways
- Using equity in your existing home as a deposit for an investment property can provide access to significant cash and offer fixed interest rates and flexible repayment terms.
- This financing strategy may allow you to avoid Lenders’ Mortgage Insurance (LMI) and simplify the qualification process compared to traditional investment loans.
- Considerations include increased financial obligations, the risk of foreclosure, potential negative equity in a declining market, and additional costs and fees associated with the loan.
- Accessing your equity includes assessing your financial standing, calculating your borrowing power, seeking expert advice, researching the property market, choosing the right loan product, applying for financing, conducting due diligence, settling the purchase, and effectively managing your investment property.
Now that you have a comprehensive understanding of how equity works as a deposit for buying an investment property, you can confidently explore this financing option and make informed decisions on your property investment journey.
Remember to seek professional advice and carefully evaluate your financial situation and personal objectives before proceeding. Happy investing!
