Put simply, equity is the difference between the value of your home and how much you owe the bank against it. So if your home is worth $400,000 and you owe $220,000, you have $180,000 in equity.
The great thing about equity is that you can use it as security with the bank and borrow against it:
- to extend your home
- to buy a car
- to go on a holiday, or
- for any use the bank allows.
Most importantly, you can use the equity in your home to buy an investment property.
However, it’s important to be aware you can’t use all of your available equity. Since the bank is lending you money against the value of your home, they won’t lend you the full amount. You see, if house prices dip, they don’t want to have a security that is worth less than a customer owes.
Typically, banks will lend you 80% of the value of your home, minus the debt you still owe against it. However, it is possible to borrow more than 80% by taking out Lenders Mortgage Insurance (LMI).
Let’s look at how much the bank might let you borrow at 80%.
Value of your property x 80% = $________
Minus your debt = $________
So for example, using the method above, if the value of your home is $400,000 and your debt is $220,000:
$400,000 x 80% = $320,000
Minus the $220,000 debt against your home = $100,000 of useable equity.
So what value investment property can you buy with your useable equity?
Well, a simple rule of thumb is to multiply your useable equity by four to arrive at the answer. So 4 x $100,000 means your maximum purchase price for an investment property is $400,000.
But why multiply by four?
If you are buying an investment property worth $400,000, the bank will lend
against your future property just like they would against your current home. As we know, the banks will lend 80%, or $320,000 in this scenario, but the property costs $400,000. This leaves an $80,000 gap, which is your deposit.
You also have purchase costs like stamp duty, legal fees and so on. This works out to around 5% of the purchase price, ie. about $20,000 on a $400,000 property. Therefore, the total amount of funds required to purchase this $400,000 investment property is now $100,000. $80,000 deposit plus $20,000 costs.
So if you multiply $100,000 by four, you get $400,000. The value of the investment property you can purchase.
One more thing
You may have lots of equity but that does not mean you can borrow against it. The bank takes in to account your income, how many children you have, any debts and a range of other items. Before you get serious about investing speak with your banker or broker.
But please, above all, remember to stay safe. If you don’t have any spare funds aside from the equity in your home, then do not use all your usable equity to invest in property, just in case you need to draw on it in the event of an emergency. Even if it means you can’t invest for a while, it is always important to keep yourself protected.
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The Successful Investor – Disclaimer
The information in this article has been written by Michael Sloan is provided as an information service only and therefore does not constitute financial advice and should not be relied upon as financial product advice. None of the information provided has taken into account your personal objectives, financial situation or needs.