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Whether you have one investment property or a multimillion-dollar portfolio, you can use equity to fast-track your asset acquisition. So how does it work and how can you get more of it?
What is equity?
Have you ever read a property investment article in which someone refers to ‘tapping into the equity’ of one of their properties, perhaps the family home?
When researching property investment, phrases such as ‘extracting equity’, ‘maximising equity’ and ‘accessing equity’ are likely to come up, but it could seem like the territory of advanced investors with established portfolios.
Put simply, equity refers to the difference between a property’s market value and the amount of money owing on it. Equity is for everyone – it’s a tool that, provided you use it responsibly, can enable you to continue growing your portfolio, even in the absence of cash savings.
As an example, if you had $300,000 left owing on a property that was purchased for $400,000 and which is currently valued at $500,000, you would have $200,000 worth of equity in that property.
You ‘own’ $200,000 of the $500,000 property, which is your equity in the property.
Equity can be calculated on any property you own – including the family home. This is a popular way for first-time investors to enter the market.
Equity can also be created in different ways – paying down your mortgage, riding a wave of capital growth and benefiting from the increased value of your property, or manufacturing equity by renovating and increasing your property’s worth.
Using equity to take out a home loan
Not all of this equity is ‘useable equity’. When it comes to equity-based loans, banks will typically lend around 80 per cent of the property’s value minus the amount you still have owing on your home loan, so in the above example there would actually be $100,000 worth of useable equity.
Your bank may allow you to borrow against this equity to fund additional purchases, be it a deposit on another property or something else. This can be achieved by re-financing your existing loans to reflect your property’s increased value, which frees up capital, or by taking out a new loan against this equity in order to fund deposits on further properties.
A line of credit loan can help you access the equity you’ve built up and access the funds even whilst some of the value of the property is encumbered by a mortgage.
This type of loan (also known as a home equity loan) is a flexible lending solution that allows investors to borrow against the equity in their property – and choose how often and how much to withdraw. Repayments are based on how much the borrower withdraws each month from the available balance.
This method of extracting equity is often used to fund renovations to a property, or to fund deposits on further properties.
The money is accessible without the borrower having to apply for funds.
The form that this takes varies from institution to institution, but access can be in the form of a dedicated cheque, card or internet banking account. As long as the borrower doesn’t withdraw more than the limit of their agreed equity amount, they can access as much of the amount as and when required.
What are the risks and benefits of using equity?
The primary benefit of using equity to build your portfolio is that you may be able to use it to accumulate wealth more quickly than if you were simply trying to save up additional cash.
By using equity, you can add properties to your portfolio at a faster rate, and the more properties you have in your portfolio, the more equity you can potentially generate. It becomes a cycle which you can easily capitalise on. Equity enables you to create a domino effect with your property acquisitions.
If you want to make the most of the equity in your portfolio though, you do need to structure your finances correctly and be on top of your budget – even if you’ve managed to invest in a fast-growing location and have plenty of potential equity on hand, a bank will still assess an application on other aspects, such as your current income, dependents and any outstanding debts.
It is also important to note that high equity growth does not necessarily translate to high rental yields, meaning that a property may generate enough equity to fund further purchases but not enough cash flow to cover current loan commitments.
Over-leveraging your assets is an important risk with an equity-based investment approach, and it is a significant consideration when expanding your portfolio.
Investing in properties that appreciate in value is key to the strategy. If you invest in a property that goes backwards in value, you may find yourself struggling to service all of your home loans as a result.
The way to avoid this is to ensure you include a buffer margin in your repayment calculations before you decide to take on new loans using equity. Make sure you can afford to repay the loan in the direst of circumstances, and also ensure that you don’t use your equity to invest in just one location or class of property.
Many property professionals also encourage investors to avoid cross-collateralisation when using equity, because it can hinder their ability to build their portfolio quickly. If investors have one property which has increased in value by $100,000 and another which has decreased in value, they may not be able to access the equity they’ve accumulated in their better-performing properties if all assets are tied together.
In these situations, investors are often advised to spread their loans between different lenders and only ever tap into a finite amount of funds, so they don’t overextend themselves.
How can I maximise equity?
You can maximise your equity by undertaking value-adding projects on an investment property. This might simply be in the form of cosmetic renovations such as re-painting and re-carpeting, or full-blown renovations involving kitchen and bathroom replacements.
Extending a property or adding an additional form of accommodation such as a granny-flat can simultaneously add equity while increasing cash-flow opportunities.
The important thing to remember with these sorts of projects is not to overcapitalise in a bid to increase equity. Having the property revalued at a significantly increased amount will mean nothing if you have spent almost as much money on renovation works.
The easiest way to add equity fast is to research your investment thoroughly, and buy in a suburb or town that is primed for short- and long-term value increases.
Buying into areas slated for future infrastructure projects, or set to benefit from industry-related opportunities is a way to do this.
Buying a property under market value is another way to maximise equity generated – this again requires plenty of research and a firm grasp of the local property market. Doing this is often referred to as ‘creating instant equity’ since from the moment you settle, your property is worth more than the amount you paid for it – giving you future opportunities to extract the new value.
Buying into areas slated for planning changes – particularly changes which allow for subdivision projects, is another way to release equity within a short time period. Sometimes you may not even need to undertake a project to maximise your equity – simply applying for a permit may be enough to see your investment property revalued at a significantly higher figure.