A person may use their existing home equity to invest in their next property. In fact, done well, it can be a useful strategy to get on top of your finances. But what are the associated benefits and risks?
Equity in a nutshell
Put simply, equity is the difference between the value of your property and the amount of your remaining loan against it. For instance, a home valued at $400,000 with a $200,000 loan outstanding would have $200,000 worth of equity.
How much equity can I use?
Lenders usually set an 80 per cent limit on the amount of equity you can use. This provides the lender with a buffer in the event of fluctuating property prices or interest rates, in case they need to foreclose the property to discharge the loan. In other words, the 20 per cent buffer helps to protect lenders against too much risk exposure.
So, using the above example, a home with $200,000 equity would have $160,000 of available equity for investing.
Equity versus mortgage
Using existing equity in your home is potentially a much more straight-forward process than applying for a new loan. The lender already has your property as security for your existing home loan, so it’s a matter of borrowing additional funds against the value of that property, provided the lender can be satisfied that your application otherwise complies with its normal credit assessment and loan suitability criteria. You effectively pay your loan as normal, but have the added advantage of tapping into the value in the property for other uses. You’ll need to sign a new loan contract, often called a home equity loan – or a line of credit loan – but the process can be faster than applying for a new loan.
The downside of using equity for investing
Investing in the property market is essentially a financial gamble – no matter how well you may calculate it. As such, when you use existing equity to invest, you’re effectively taking a huge financial risk – you’re risking that:
- The existing property will maintain its capital growth.
- You will achieve a return on your investment.
When you use existing equity to borrow more funds, the amount of the property that you effectively ‘own outright’ is significantly reduced. If your investment performs poorly, you may be in a less than desirable position, compared to what would happen if you’d left the equity alone. That’s why it’s important to research the market thoroughly before investing and ensure that your finances and emotions can cope with the worst case scenario – should the unfortunate happen.
Interest paid on home equity in some instances may be tax deductible. However we recommend you speak to your accountant or tax adviser to get more information and determine whether borrowing against the equity in your home is an appropriate strategy for you.
There are a number of ways that you can access your equity, whether you want access to part or all of it. The options include a redraw facility, an additional advance or mortgage refinancing. Find out more about the ins and outs of accessing your equity.