Quite simply, it’s the difference between the value of your property and the outstanding debt on your home loan. For example, if Sarah’s home is worth $500,000 and the current debt on her home loan is $320,000, then she has $180,000 worth of equity in her house.
A common misconception is that you can use all your equity to buy an investment property. In most instances, you could borrow up to 80% of the value of your home.
With this in mind, here’s how Sarah can calculate her usable equity:
This means Sarah has $80,000 worth of usable equity to put towards a deposit for an investment property, as well as other buying costs like stamp duty and settlement fees.
If the usable equity isn’t enough to cover the full deposit and any stamp duty and settlement costs, Sarah will also have to make a cash contribution.
In most instances, you need a 20% deposit to get a home loan to buy an investment property.
Therefore, if Sarah uses $80,000 worth of equity as a deposit, she could purchase a $400,000 investment property – assuming she covers stamp duty and settlement fees with money she’s saved, and she meets the necessary criteria to get the loan.
It’s possible to buy an investment property with a deposit lower than 20%, but you’ll most likely have to take out Lenders’ Mortgage Insurance (LMI). This means you’ll probably have to pay an additional fee (approximately 2 to 3% of the loan amount), and your interest rates on the investment loan may also be higher.
When it comes to your usable equity and borrowing power, a Home Finance Manager can talk you through the possibilities.
Using equity is a great option to potentially lock in a better interest rate, and avoid paying Lenders’ Mortgage Insurance (LMI). Keep in mind that the property you’re taking equity from will become additional security for your new loan as well – we call this cross-collateralisation. In the future, this means any decisions you make to one loan or property may impact the other.
For example, if you sell one property later, the money from the sale may be used to reduce your other loan. It all depends on the value of the property you’re keeping and how your remaining repayments might impact your situation.