Smart Investor Getting Started: Using Equity in your Home

Smart Investor: Getting Started, January 2011

The idea of using the equity in your home to start a property portfolio has a lot of appeal. You don’t have to use a lot of savings; you don’t have to sell anything; you just use something you already own to anchor a new investment.

Here’s how it works. Your equity in your home means the amount of it you own – the value of your home, minus whatever’s outstanding on your mortgage. If you have a home worth $500,000, and your outstanding debt is $200,000, then you have $300,000 of equity in your home.

You can use that equity to make other investments, such as buying another property. There are two ways to do this: you draw on your existing home loan (sometimes known as a redraw), or get a new line of credit, whether from your existing lender or a new financial institution. You use that money as a deposit on an investment property, and get a new loan for the balance of the acquisition price.

There are a few considerations before you try this, starting with working out how much capital you will be able to get. If you are looking for a line of credit, banks will be having a look at how much equity you have in your home and deciding what proportion of that they are prepared to lend you. Typically, these days the maximum is 70 to 80% of that equity. Banks used to lend much more before the financial crisis, but those days are gone, and with good reason: being too highly geared can get you into a world of trouble if circumstances turn against you, such as losing your job, losing your tenant in an investment property, or interest rates rising quickly.

The rate of interest on a secured line of credit is usually slightly higher than a home loan, and naturally you need to be comfortable that you can meet the additional repayments to service this facility. Keep in mind that this line of credit will be secured against your own home.

Then, there’s the new investment loan. Again, the bank will be looking at a few things in deciding how much to lend to you: the size of the deposit you’re able to put down; and what your income and assets say about your ability to make repayments. The key measurement banks use here is the loan to value ratio: again, banks these days are unlikely to go far beyond lending you 75% of the value of the property.

Doing these sums allows you to work out how much money you have to play with, and therefore how expensive a home you can afford. Next, you need to work out what rental income you can reasonably expect from that property, and how it relates to the repayment costs on your new investment loan.

This is where you get into questions of negative and positive gearing. If your rental income is less than your loan repayment, you are negatively geared. If it’s more, you are positively geared.

Australians have a habit of actively seeking out negative gearing, because it comes with a tax advantage. The shortfall between your rental income and the interest you repay on your loan can be used as an offset against tax, and you can see this tax refund as an additional source of income from the investment property. That’s fine – but some people get so fixated with the tax implications that they forget about the point of being in the investment and the first place, and find themselves getting into a debt hole where they can’t find the money to make repayments. It’s worth sitting down with tax and financial advisors to discuss your own circumstances.

If you have more money coming in from rent than is going out on repayments, that presents another question: what to do with it. Advisors suggest repaying your home loan. “The interest on the debt on your family home is not tax deductible, while the interest on your investment loan is tax deductible and will reduce your liability to tax,” says Kevin Sudlow at Multiport. So it’s better to pay down non-deductible debt on your home than deductible debt on an investment property.

What are the cons of using home equity to buy a new property? “You are now servicing two loans, which isn’t a problem if you can service both loans,” says Sudlow. “However if the rental payments you receive don’t cover your loan repayments, you will need to contribute that extra money to fund the investment loan repayments.” And if interest rates rise, that will become tougher.

BOX: An example

Kevin Sudlow at Multiport maps out the following example of using equity to build an investment portfolio.

Steve and his family live in a property worth $700,000, with an outstanding debt of $300,000, meaning he has amassed $400,000 of equity in his family home.

Steve has found a $500,000 unit he would like to buy as an investment. His financial institution agrees to establish a $280,000 line of credit for him – that is, 70% of the value of the equity he has in his family home. He draws $150,000 from this line of credit, and uses it as a deposit on the unit, and pays the balance, $350,000, with a new loan.

So what’s happened? Steve’s got an investment property without having to use any cash savings, or sell any other assets – he’s just used the equity in his family home. He uses the rental income from the new property to repay the loan on that property.

But let’s say the rental income doesn’t cover the interest on that loan. This is what’s known as negative gearing, and it has two impacts: he needs to come up with the cash to cover the shortfall; but he also has a tax benefit. Let’s say his rental income is $10,000 per year and the interest on the investment loan is $15,000, creating a deficiency of $5,000 that he will have to come up with from elsewhere. That deficiency is deductible from other income for tax purposes, so if Steve is paying tax at 31.5%, he will have a saving of $1,575, adding to his investment return.

What if it’s the other way around, and his rental income is greater than his interest costs? If he receives $15,000 a year in rent and the loan repayments are $9,000, he is better off diverting the extra $6,000 to paying down the outstanding debt on his family home, as that is not tax deductible, whereas interest on investment loans is deductible.

While Steve has acquired a new property, he has also acquired risk: he is now servicing two loans, and if he should find himself without a tenant in his investment property for any length of time that is likely to become a major financial strain. Steve, like anyone in this position, should work out just how stretched he would be if that were to happen or if interest rates were to rise sharply, and ensure he is comfortable with the answer.