Investors often talk about tapping into their equity, but what does that actually mean? And how can it help you get more properties, more quickly in the current market?
Blogger: Todd Hunter, director, wHeregroup
And for those homeowners and investors who have had the great fortune to see their property values skyrocket, what’s next?
Why not take advantage of the fantastic values on offer and tap into some of that equity and keep investing?
But what does 'tap into our equity' actually mean?
Similar to when you purchased your property, the banks would only allow you to borrow up to so much of the value of that property. This is called your loan-to-value ratio (LVR). Well, provided you can service the debt at the increased amount (make the repayments), the banks will allow you to increase your loan up to a certain LVR and use that cash for a deposit on an investment property.
The great part about that is that the increased amount that you use as the deposit on another property is tax deductible, even though the banks used your home as security for the funds.
Purely because what makes a loan tax deductible is the purpose for which those funds were used.
Like usual, let’s number this out.
Say three years ago your home was worth $600,000 and your home loan was $480,000. Your LVR is 80 per cent because $480,000 is 80 per cent of $600,000. But in the past three years your home has seen some great increases in value and it is now worth $850,000.
The banks will now allow you to increase your loan to 80 per cent of $850,000. So your new loan would be $680,000. But you only owe $480,000 so there is $200,000 available for you in funds, in your offset account or in redraw, ready for you to use when you locate another property.
Now to keep your accountant happy, it is best to split the $680,000 into two loans, one split for $480,000 and the second as $200,000. That way your accountant can easily work out the interest on the loan that they can claim on your tax each year.
Obviously, this is how we would structure your loan and explain all this to you as we go.
At the same time as arranging the extra cash for you to use as a deposit, we would arrange a pre-approval for you so that you could purchase an investment property.
Even if you have some extra money paid off your home loan, do not use this but instead continue to make the extra repayments on your home loan to pay this off first. Simply because this debt is NOT tax deductible.
You should restrict the maximum amount you aim to spend on an investment property, and that should be nowhere near the value of your home.
Even as a professional investor I don’t spend more than $425,000 on a property. My last four purchases were for:
$410,000 – ACT
$40,000 – US
$356,000 – Queensland
$134,000 – Tasmania
The advantages of spending less are:
• Less to lose, if by some chance everything turned pear-shaped (always invest with worst case in mind)
• Potentially be able to invest in different markets and take advantages of different property cycles
• Baby steps – especially if this is your first go. I see couples where one wants to invest much more than the other, and it’s not worth fighting over.
• You’ve only got one life and it ain’t no dress rehearsal. (Sorry if I just went all Dr Phil on you)
• Yields are generally more attractive and the properties will pay for themselves
So back to the story, we have set up a pre-approval at the same time for you for a purchase price of $375,000. The loan would be for $300,000 which is an 80 per cent LVR.
But there are some set up costs along the way to, for example:
• Stamp duty – varies state to state
• Legals to purchase
• Building inspection report
• Pest inspection report
• Depreciation schedule report – for tax purposes
• Government charges
• Buyer's agent's fees – because you will want me to buy you a property
The great thing here is that you can pay for all these from the $200,000 loan you have already set up.
Yep, that’s right, nothing from your pocket… and the interest these fees attract on that loan is also tax-deductible.
Now, to make that transaction work you only need about $100,000 and you have borrowed an extra $200,000, meaning you have the option later to purchase a second investment property. But tapping into the equity now while the values are high could give you the option at a later date. When values go through a correction you may not get that privilege. And you only pay interest on the money that you have used, e.g. the $100,000.
Not everyone is in a position to tap into their equity and invest, as they may have borrowed 95 per cent of the purchase price when they recently purchased.
What you may have been experiencing, is that there are some much better interest rates on offer. They can be as much as 0.5 per cent better.
So what can be done about this?
First, interest rates are now allocated as rate for risk, meaning those borrowers considered to present a higher risk to the banks are not on the same interest rates as those borrowers who own 20 per cent or more of their properties.
And this risk is judged on the value on the day that a valuer puts a dollar figure on your property. So as we have experienced some great growth in the Sydney and Melbourne property market, you may now find that you do own 20 per cent of the property value now.
But be quick, because this great market isn’t going to stick around much longer and you want to capitalise on the maximum value we can achieve from a valuation.