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Using equity to buy investment property

With the median house price in Perth hovering around half a million dollars (and close to a million dollars in the eastern states), it is easy to understand why investors are struggling to find upwards of $100,000 which is the minimum 20% deposit required when purchasing an investment property. As a result, many investors are looking at using equity to buy investment property.

So, what is equity?

Equity is the difference between the value of a property and its mortgage. A home worth $400,000 with an outstanding loan balance of $250,000 has equity of $150,000. Lenders will look favourably upon any equity you have built up in existing properties and in many cases will allow you to use this equity to borrow money.

In certain cases, the equity does not even need to be your own. You may have a family or relative who has equity in an existing property which you can use as a deposit to purchase a property. This is becoming increasingly popular for first home buyers and investors whose parents are keen to help them out. But although it sounds like a quick and simple solution, using equity to buy investment property comes with its rewards plus some important considerations.

Firstly, you might be asset-rich but cash-poor meaning you have built up wealth in the value of the properties that you own but you don’t have a great deal of disposable income available to you. It may all be tied up in your properties which is fairly common for older people, particularly retirees, who are no longer receiving a regular income each month.

If this is the case, based on your equity the bank may be willing to lend you a significant amount of money but you need to make sure you have the cash flow available to service your property loan, as well as the equity to cover the deposit. If you do not have the cash flow (or sufficient rental income to cover the investment loan repayments) your finance may be in jeopardy which can place your property portfolio at risk.

Secondly, if you are using equity to buy investment property it is recommended you set up each property loan as a separate loan, rather than cross-collateralise your portfolio.

A cross-collateralised loan in one where another property is included as security for a mortgage under a single loan. This may happen where an investor finances multiple properties through the same bank. It is a strategy used by banks to improve their security on a loan and can be used by an investor to boost their borrowing power or to avoid paying mortgage insurance when they have less than a 20% deposit.

However, cross-collateralised loans can be restrictive to an investor, where they seek to build a portfolio by using equity in existing properties to purchase additional ones. Where a cross-collateralised property is sold, a bank may reserve the right to direct proceeds of the sale towards payment of other loans in that portfolio. In that case, the loan proceeds would not be able to be used at the investor’s discretion.

In addition, in a cross-collateralised portfolio, if one property has equity that you wish to invest further but another property has negative equity, the overall portfolio position may render the equity inaccessible from the bank’s perspective.

When using equity to buy investment property, cross-collateralised loans should be avoided where possible. Instead, investors should seek to mortgage each property separately. You can use the equity in one property to help finance the deposit and borrowing costs for a new property and then set up the mortgage as a separate loan, which ensures one property will not be affected by another if there is a need to sell at a point in the future.

The following example demonstrates the two scenarios, one involving a cross-collateralised loan and the other with separate loans.

Case study: cross-collateralisation

Jack’s home is worth $600,000 with $200,000 outstanding on his mortgage. He wishes to use some of that equity in his home to finance an investment property that costs $400,000.

Cross-collateralised option:
Jack may have the option to borrow $420,000 to purchase the property, plus costs. While he avoids having to make a cash deposit, his loan is cross-collateralised with his family home. In essence, Jack’s two properties worth $1,000,000 are being used as security for his $420,000 loan.

Non cross-collateralised option:
Jack establishes a new loan against his home for $100,000 (to cover the $80,000 deposit and $20,000 stamp duty and other costs for the new property). This takes his total loan on his family home to $300,000 although for tax reasons the interest for the additional $100,000 would be tax deductible.

Then a new mortgage of $320,000 (the remaining 80%) is established, either with the same bank or another lender that provides more favourable terms. If Jack had a long-term goal to purchase several properties over a few years, he could make the initial loan against his home large enough to cover the minimum deposit for three properties, ensuring he has preserved equity ready to use when the opportunity to purchase arises (provided he has the cash flow to sustain this approach).

By choosing the non-collateralised approach, investors have greater flexibility when using equity to buy investment property. It also places less risk on the property being used as security which is very important, particularly if the property is owned by your parents or a family member.

It is also important to remember that equity can be used for other opportunities besides purchasing a new property. For example, equity can be used to borrow money to renovate or improve a property to increase the income that property is able to generate.  There are many opportunities available which are worthy of consideration.

So while the values of properties across Australia remain high and the cost of borrowing money is the lowest it's ever been, now is a good time to explore the option of using equity to buy investment property.

If this is an option you would like to explore further, contact an Investor Assist Property Investment Specialist on 9200 7200 or contact us here for details. Alternatively, we can direct you to one of the highly experienced finance experts at our partners at Resolve Finance or BlueBay Home Loans for specialised finance information about re-mortgaging your existing family home or other properties to avoid cross-collateralising your portfolio. Using equity to buy investment property is a smart choice but it always pays to talk to the experts!