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In the property investing world, equity is the magic word that everyone is chasing! But what exactly is equity, and why is it so magical?
I remember I used to wonder about these questions as I start my journey, so today let's uncover a bit about what equity is and how you can use it in your next purchase.
In simple real estate terms, "equity" is the additional value a property contains.
A simple example:
Current value of a property - $600,000
Loan on the property - $300,000
Equity of the property = current value minus loan - $300,000
Now, equity is usually realised in two common ways:
1. By selling down the property to obtain profit
2. By leveraging more with a lender, as line of credit (LOC)
Selling down the property is quite straight forward; the net profit you get after factoring in all costs of sale is your equity. With this approach, the equity comes in as cash form.
But if you don't want to sell down, think of it as taking the property up to a financial institution as a leverage to negotiate in order for you to lend more money from them.
This is the more common approach for investors as they do not need to sell down the asset, but is able to "extract equity" of a property and use it towards the next purchase. The "extracted equity" comes into a form commonly known as Line of Credit, or LOC.
When you have an LOC setup you'll most likely see two lines in your bank account:
1. A loan account for the LOC established (what you owe to the bank)
2. An offset account linked to the LOC, with the same value (this is the equity you can use)
One important clarification here — LOC is a type of loan and not free cash. If you draw down the amount in your offset account, you'll be charged with repayment, so it's important to understand this concept: extracted equity via LOC is borrowed money, but it can be used as the stepping stone to expand your property portfolio.
Also, at the time of writing, most financial institutions are only willing to set up LOC up to 80 per cent of the property value. So, using the example we have above:
Current value of a property - $600,000
Loan on the property - $300,000
LOC = 80 per cent of property value minus existing loan - $180,000
Also note: because LOC is a type of a loan, banks will have to conduct their lending assessment to see if you can service the additional amount.
Continuing on from the example above, the $180,000 sitting in the offset account of an LOC is fund that can be used towards the next purchase in the form of a deposit. Let's say Bob has extracted an equity of $180,000 from his principal place of residence (PPOR) and now wants to purchase his first investment property, which we can call IP1.
IP1 sales price: $600,000
Loan required (assuming at 80 per cent loan-to-value ratio (LVR)): $480,000
20 per cent deposit required: $120,000
Purchase cost (stamp duty + conveyancing, etc) = roughly 5 per cent of sales price = $30,000
So in this case, instead of funding the deposit + purchase cost using his cash savings, he can fund it straight from LOC, and Bob can use his free cash for something else or towards his next purchase.
There is also an additional benefit here; since the borrowed money (LOC) is going to be used for investing purposes, it will be tax deductible.
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