You probably have heard about home equity and that one can use it to buy their next home with little to no deposit at all. While this can be true, not too many people truly understand equity as well as how using it can affect them financially. While it is certainly true that equity can help reduce the cash deposit you need, a lot of people tend to forget that it has an impact on how much you can borrow for the next property. In today’s article, we will go through how home equity actually works, and what you need to pay attention to when using it.
What Is Equity
Equity is the difference between your home value and its existing loan. This means each property, whether owner-occupied or investment, has its own equity. At any time, you can get a valuation of your properties and compare that to the mortgages you currently have on each of them. If the mortgage is less than 80% of the home value, you have what we call “usable equity” which is what really helps your next purchase.
Calculating usable equity is quite simple. You just take 80% of home value and minus the current mortgage. For example, let’s say your home is worth $1 million, and you have a $200,000 mortgage on it. Take 80% of $1 million, which is $800,000, minus $200,000 current mortgage, you now have $600,000 in equity that can be released as deposit for the next home.
So why 80%? That is because equity is another loan, and it is most cost-effective to limit your total loan to 80% of any property. Let me repeat that, releasing equity means taking out an additional loan, and you should limit total loan to 80% of any property.
Some banks do accept 90% loan even for equity release. However, you will be charged additional insurance fees as well as higher interest rate, which significantly increase your cost. You should only consider 90% loan if you have really good reasons for them.
Advantages of Equity
If your real estate has usable equity, it means you have been paying down your mortgage by a substantial amount. This is wealth you have accumulated, so taking it out is a good idea if you can take it out and put into other investments.
Another way for equity to accumulate is through property price growth. In other words, your wealth has increased without you doing anything. You can grow this even further by using it to fund the next opportunity.
It can be very effective in helping you grow your portfolio quickly. Saving up a deposit can take years, especially when you are paying a mortgage. Instead, you can reborrow what you have paid plus part of that capital growth that the market just gave you to fund the next one. When you have 2 or 3 properties growing capital at the same time, this can be quite powerful.
Having a large equity can help reduce interest rate on the next loan. This is because most banks give you better rates if your loans are only 60% or 70% of your total home value. Equity can be used in a similar way as additional deposit, effectively reducing your borrowing level and interest rate.
Equity can also be taken out for many different reasons, not just to buy real estate. These includes paying off other loans, minor upgrades to your home, or personal consumption. Since mortgage rates tend to be the cheapest compared to other types of loan, this can be a great way to clear off high-interest debts or cover a short-term expense.
Disadvantages to Consider
Equity is value that you have locked in the home. There are only 2 ways to turn that value into cash: sell the house or borrow against it. We are talking about growing your portfolio, so selling is not ideal. This means your only option to use equity is to borrow.
Taking out a loan always has its risk, since you can easily overstretch yourself. This is especially common during times of low interest rates like a couple of years ago. Many people pushed their borrowing through cheap rates, only to struggle when rates come back up eventually.
Since you take out equity because you don’t want to pay a big deposit, it also means you are borrowing a higher percentage of the investment property. In fact, some do borrow more than the purchase price to pay for closing costs if possible. If market turns bad, you could potentially have negative equity on your property.
Most importantly, equity is limited by your borrowing capacity, which is determined by your income and expenses. If you have reached your maximum borrowing capacity, the banks will not lend you any further regardless of how much equity you have. This is not uncommon, especially for those who have owned their properties for a long time, rising real estate prices with slow wage growth over the last few decades cause a lot of people to sit on large equity with no easy way to access them.
As a side note, This needs to be in your name! You cannot use equity in someone else’s home. This may sound obvious, but I did receive this question before so just want to put it out here. Now, some of you may be able to use equity in your parents’ home, but it is only for very specific circumstances and has very little to do with what we are discussing here. This is call Family Equity and it is a different topic entirely. In most cases, equity needs to come from your own home and can only be taken out for your own use.
As a summary, home equity is a powerful tool that can help you build up an investment portfolio with relatively little cash upfront, as long as you understand how to use it correctly.
If you have any questions that you wish I had covered, do leave them in the comment section and I will do my best to answer them. Until next time, stay sensible.
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