How equity works its magic:

The value of your present home can be tapped to help you climb further and faster up the property ladder

Many people are at a loss when it comes to financing a property that, on paper, is negatively geared. They’re uncertain how they’ll make up the cash flow shortfall that often comes with well-located, high-capital-growth property, as opposed to a high-yielding, “pays for itself” rental investment.

On the other hand, some people never even consider starting a property investment career because they believe they simply can’t afford it. They think, “How can I possibly pay off my own home while I’m saving a deposit for another one?”

Equity equals opportunity

Equity is often overlooked when it comes to property finance. Equity is the net realisable value of a property – or how much cash you’d walk away with after you deduct sale costs, outstanding debt and capital gains tax from what the investment is currently worth.

However, there’s another definition of equity that’s relevant when you start talking about using equity as financial leverage – borrowable equity. This is essentially the property’s value multiplied by 80% (with 80% representing the amount you can generally borrow without the need for mortgage insurance), minus whatever you owe against the property. For

instance, if a property is worth, say, $500,000, you can theoretically borrow $400,000, but if you already owe $300,000 against the property, your borrowable equity will be only $100,000 – the extra amount you can borrow using the property as security.

The true beauty of equity is that it increases over time, isn’t taxed like your hard-earned savings are, and can be used to help you climb the property ladder much faster than you can if you save cash to use for deposits on further investment purchases.

So can equity work to increase your borrowing capacity, build your portfolio and keep your cash flow on track?

Deposit power

Many people who consider getting into property investment feel that before they can make a move, they have to work their behind off to repay their home loan and become debt free. This would be a dream come true for most of us, but the reality is it can take a very long time to do it and in the meantime you could miss out on potentially lucrative investment opportunities.

Most homeowners are sitting on a goldmine, with substantial equity in their property, and they don’t even know it. Equity is like the goose that lays the golden egg, in the sense that it can build on itself in a variety of ways and continue to grow and work for you.

One way that equity can increase your potential to make even more equity is by using some of the capital you have in your own home as a deposit for investment purposes. It’s much easier to rely on the escalating capital in your home, rather than trying to save a deposit from scratch, for two reasons. Firstly, equity is not taxed like income (not until you sell it, anyway) and, secondly, the natural growth in value of a well-placed property will far outweigh any interest you could earn via a savings account.

In other words, if you’re keen to build an investment portfolio in property, you’re far better off adjusting your mindset to the idea of borrowing more, rather than scrambling to pay off your home.

The key is to buy a good quality asset, then let capital growth work its magic over many years and decades, while you refinance to release borrowable equity that you can use as a deposit. There you have it – a simple way to step up the property ladder.

Loving the leverage

When it comes to equity, the more you have, the more agreeable you’ll find lenders will be when it comes to handing over extra borrowings. This is because equity in a property provides them with greater loan security. Using equity in this way is known as leverage and it’s an excellent way to gain progress in your propertyinvestment endeavours (see case study).

Buying property that pays

This might all sound promising, but there are several factors that can bring the equity equation unstuck for investors. The most crucial element to being able to access and use equity in property is the actual building of enough capital to generate adequate amounts of the stuff in the first place.

From this perspective, I can’t stress enough how important asset selection is. You need to be investing in the highest-quality assets, so that you maximise your chances of enjoying strong capital growth. I discuss this in detail in my book Investopoly. Even more importantly, you need to regularly review the performance of the properties you own. You should never settle for second-best, and so you should dispose of any underperforming properties as soon as possible. This is something the vast majority of investors don’t do for many reasons: I suspect the primary motive is that they don’t want to admit they picked the wrong property!

You should be looking for an average capital growth rate of 4% to 5% above inflation, at the very least. Even a 1% differential in capital growth will result in an almost $500,000 difference in equity after 20 years (on a $750,000 property).

That’s why I believe that before you buy an investment property, you should seek professional advice (or at least a second opinion) from a qualified, independent investment property adviser. With so much potential wealth on the line, you’d be silly not to. Purchasing the wrong asset can be very costly in terms of stamp

duty, subsequent selling costs and, more importantly, lost capital growth.

From a credit perspective, lenders often consider the location of a property. If people are buying high-capital-growth properties, demand will outstrip supply and that makes lenders feel confident they can realise that asset in a timely manner if required. In other words, if the wheels fall off and you can’t make the repayments, the lender knows that they’ll probably be able to sell the asset quickly and for a reasonable price.

How do I release my equity?

Once you’ve come to terms with the idea of using your equity to either start out in property investment or add to an existing portfolio, how do you actually get hold of your equity? What practical methods of refinancing or restructuring are the safest, and what are the pros and cons of using various loan structures to release your equity so it can work for you?

LINES OF CREDIT

There’s no denying that a line of credit can be a handy way to access equity, and is often recommended to investors as the easiest option. Many lenders and mortgage brokers suggest that lines of credit are beneficial because they provide borrowers with flexibility in terms of availability of funds, transaction capability and loan repayments, all at home loan rates.

It’s true that a line of credit allows investors to withdraw the funds they need (up to the agreed limit) for a number of purposes – such as to put down a deposit or purchase an investment property. However, in my experience, less than 5% of the clients I deal with would benefit from using a line of credit to access their equity. Generally speaking, a line of credit is more expensive than other loans, because most lenders charge a higher interest rate for them. There are many other loan products that allow you to access equity without having to pay any interest at all, until you use the money. This is of great benefit if you intend to use your equity for a deposit on an investment property, as you’ll need to set up the loan facility before you make the purchase.

For this reason, I’d suggest that as an alternative to a line of credit, investors should consider a loan with redraw or an interest-only loan with an offset attached. Although a line of credit can be a good option, there are often lower-cost products that allow easy access to borrowable equity.

SECOND MORTGAGES OR REFINANCING

A second mortgage is taken when an investor approaches another lender, with whom they don’t have their initial mortgage, to take out a loan against their home or another property they own. For instance, if you were to decide you want to access your equity to put a deposit on another property, you might approach the Commonwealth Bank, when your initial home loan is with Westpac. You’d end up with two separate mortgages from two separate lenders against the one property: Westpac holds the first mortgage and Commonwealth Bank has to register a second mortgage.

This isn’t really a popular option these days, and most lenders avoid second mortgages wherever possible. The secondary bank is uncomfortable with such a set-up, because it knows that the initial mortgagee will be paid out first should anything go wrong – as a result, it will often lend a much lower LVR to obtain a higher security buffer. Therefore, it’s not an efficient use of equity.

Generally, these days you’d refinance with the lender who already holds the mortgage on your home and establish a second account with them – this is often called an “internal refinance” or restructure. Alternatively, you’d refinance everything to a new lender and establish two new accounts – often called an “external refinance”.

An internal refinance has some distinct advantages. Your existing lender can establish a second loan account just by setting up a new loan agreement. This means they simply rewrite the existing mortgage contract, or create a totally separate mortgage contract, but generally don’t need to change the registered mortgage itself, as they already have a charge over that property. They’re really just using the equity in it. They would revalue the

property, do the sums to work out how much borrowable equity can be released, then give you access to those funds by establishing a new account (assuming you can afford to borrow the money, of course).

When you establish a second account in this manner, you can opt for either an interest-only basic variable loan or an interest-only package-type loan with an offset facility. The basic variable loan would be fully drawn on the day it’s established, and you would then take the money and repay it back into the loan, leaving a small portion outstanding (say, $100), and redraw this money as required for your deposit. With an interest-only package-type loan, you’d deposit the loan funds you can access (let’s say, $100,000) into the offset account. Because the loan is offset by the $100,000 cash, no interest is payable until you withdraw the money from the offset to use as a deposit for your next investment.

An external refinance can be advantageous in three common situations:

If your existing lender refuses to match the interest-rate discounts that other lenders are offering and therefore becomes too expensive; If your existing lender values your property at less than what you think they are worth (and what another lender will value them at); or

If your existing lender has a lower borrowing capacity and therefore is unwilling to approve more lending.

In all cases, these accounts need to be established prior to making an investment-property purchase, so that you can access the necessary deposit from your equity. It’s likely that both these options will turn out to be cheaper than a line of credit.

Developing a plan

As with almost everything, investing some time into developing a financing plan can be worthwhile. Most people can’t invest without finance, so it’s a pretty important thing to get right, and planning can maximise your chances of success. Everyone’s plan will be different, depending on their financial situation and goals, but remember the best time to borrow is when you don’t need it, so preparing loan arrangements for your next move is an advantage. Some of the things to consider when developing your plan include:

• Establishing loan arrangements prior to starting a family (as you may reduce to one income for a period of time);

• Understanding what stage the property market is at and whether revaluing properties now makes sense (for example, if the property market is very strong, it may be a good time to revalue);

• Considering the type of property you’re investing in and your investment strategy (for example, if you have limited equity, then it may be better for you to invest in property that will deliver some immediate equity, or equity in a short period of time – allowing you to leapfrog into another investment property);

• Considering the timing of an owner-occupier purchase and its impact on potential future property investments;

• Making sure your loan arrangements are flexible enough to accommodate any expected changes in your personal circumstances, and the cash flow consequences of these – both positive and negative;

• Being careful about repaying any loans – often it’s better to accumulate cash in an offset to reduce or eliminate interest rather than repaying the principal.