THE POWER OF LEVERAGING
Using home equity for investment
It’s a word a lot of my property investor clients know about. Leveraging is where you utilise your current assets to increase your investment portfolio. The asset in property investing is usually a property that you own – this could be your principal place of residence or an investment. There are two requirements for leveraging.
Firstly you need equity - a property where you have either paid down a portion, and/or it has increased in value. Secondly, you need the borrowing capacity to borrow additional funds from a bank.
Step one: Accessing your equity
For example, you bought a home for $500,000 with a home loan of $400,000, giving you a Loan to Value Ratio (LVR) of 80%. A few years later the property increases in value and is now worth $700,000. For simplicity, the home loan is still worth $400,000 giving you a LVR of 57%. To avoid lender’s mortgage insurance you can increase your loan back to 80% LVR = $560,000, giving you $160,000 in funds to purchase an investment property.
Sum: Property value= $700,000/80% LVR = $560,000 minus $400,000 current debt = $160,000 raised equity
Step two: Further borrowing
Now you have your funds for a deposit and legal costs, you can start working on looking for an investment purchase. You find an investment property for $500,000 which requires you to put down $100,000 as a deposit (20% - again waiving the requirement of lender’s mortgage insurance) and $30,000 legal costs, i.e. stamp duty, etc = $130,000. You now need a loan from the bank for the remainder of the $400,000.
Sum: Purchase price = $500,000 minus $100,000 deposit = 80% LVR - $400,000 investment loan required.
You’ll need to demonstrate affordability to the bank for both of the steps above. Most banks will also require you to explain what the initial equity raising is for - further investment purchase.
You now have a property portfolio worth $1,200,000 ($700,000 existing home + $500,000 new investment purchase) which is growing over time, with a debt of $960,000 ($560,000 + $400,000) = 80% LVR, which is reducing over time. This includes a $30,000 buffer remaining from the equity raised.
The above steps are one way of leveraging. You can also cross-collateralise your properties which means the properties are secured against each other. Some investors and finance professionals prefer this method as the set-up of the finance is simple, while others prefer an approach where the properties are independent of each other with different lenders.
Benefits of leveraging
It allows you to start/increase your investment portfolio without having to use your hard earned cash. Saving $160,000 can take a long time and could mean that you have to wait longer to buy the investment, in which time you could potentially lose out on further equity with increased property values.
Having spoken to your accountant, you may find that raising equity on your property could work out to be more tax effective than putting in your cash/savings. Although you’re borrowing more money and putting you in further debt, the thing to remember is that this is ‘good debt’.
Leveraging doesn’t necessarily mean that you need to buy an investment property. You may be a parent who would like to help your children to get on the property ladder and leverage your property as a security. This could save them significant time of having to wait years to save for a deposit along with missing out on potential equity. Once your children’s property is at a LVR of 80%, your property can then be released – this is called Parental or Security Guarantee.
Disadvantages of leveraging
Leveraging can prove to be destructive if measures aren’t put into place. For example, what happens if you don’t find a tenant for your investment purchase, have you got means of paying the mortgage if you lose your job, what happens if interest rates skyrocket? Leveraging does put your initial property at risk in addition to your new purchase should things not work out, which potentially includes the roof over your head.
The Australian Prudential Regulation Authority (APRA) has recently curbed investor borrowing due to the amount of debt borrowers have leveraged, more notably in Sydney and Melbourne.
A number of stress tests need to be put in place along with cash reserves, i.e the $30,000 additional income raised from the equity to cover mortgage payments and unexpected costs.
Leveraging and investing in property requires professional advice from mortgage professionals, accountants and investment property specialists. Only then should you think about using your current assets as security for additional purchases. Good Luck!
Using equity in your home to fund an investment property is a popular strategy for Australian investors