If you own property, you may have encountered the term “equity.” Here we explain what it is, how to calculate it, and what it can be used for.
What is Equity?
Equity is the difference between the current market value of your home and the outstanding balance of your mortgage. Essentially, it represents the portion of your property that you truly own. Over time, equity typically increases as your property appreciates in value and as you pay down your mortgage.
How much Equity do you have?
To determine how much equity you have available, we’d need to consider the following:
Current Value of Your Home: This is determined by a lender’s valuation, which assesses the market value of your property.
Outstanding Loan Balance: This is the amount remaining on your existing mortgage.
Lending Ratios: Generally, lenders allow you to borrow up to 80% of your property’s value. However, specific conditions may apply based on the lender’s policies and the nature of the property which may allow you to borrow less (or more) than this 80% Loan to Value Ratio threshold.
Repayment Capacity: Releasing equity effectively means taking on new debt. Lenders will evaluate your ability to manage the increased monthly repayments associated with a higher debt level, before they approve the equity release.
How to Release Equity
Equity can be released through an increase in the limit on your current mortgage, but more commonly, it’s released as part of a refinance.
What can Equity be used for?
Releasing equity can help you achieve various financial goals, such as:
- Making non-structural improvements to your home (e.g., landscaping, renovations).
- Investing in the share market, often based on advice from a financial planner.
- Assisting with another property purchase (either an investment property, or new owner occupier home).
- Paying off high-interest personal loans or credit card debts.
- Financing the purchase of a vehicle or motorhome.
It’s crucial to consider the long-term implications of these decisions. For instance, using released equity to pay off a high-interest loan might seem beneficial, but if it results in extending the repayment period significantly, it could lead to paying more in interest over time.
Using Equity to Purchase another Property
Here’s an example to show how equity can be used to finance another property purchase.
Suppose you want to buy an investment property valued at $600,000. There’s an estimated $30,000 in associated costs (such as stamp duty and legal fees) related to this new purchase, so you would need access to approx $630,000.
Typically, lenders allow borrowing up to 80% of a property’s value. This means you could secure a loan of $480,000 secured by the new investment property. However, with the total purchase cost of $630,000, you’d still need an extra $150K to complete the purchase.
One solution could be to contribute $150k in cash.
The second option could be to examine the equity position in your home, to see if you can leverage build up equity instead.
Assume your home is valued at $900,000, and you have an outstanding mortgage of $450,000. Calculating the available equity involves the following formula:
Available Equity = (Current Value × 80%) − Outstanding Loan Balance
Plugging in the numbers:
Available Equity= ($900,000 × 0.80) − $450,000 = $270,000
With $270,000 in available equity, you have enough to cover the $150,000 shortfall for the investment property purchase.
As long as you can demonstrate the capacity to meet the repayments on a new investment loan of $630,000, you could potentially finance the entire investment property purchase without needing to contribute cash at all.
This strategy allows you to keep Loan to Value Ratio (LVR) on your new loan at an acceptable level, minimizes the cash contribution required, can help you secure a more favourable interest rate. It also means you’re maximising your investment lending, which can help to maximise your deductions from a taxation perspective. (This does not constitute tax advice; you will need to consult a taxation agent and conduct your own research to see what applies to you personally.)
Leveraging equity in your existing property can be a powerful strategy to help finance the purchase of an investment property. By understanding how equity works and calculating the amount you can access, you can make informed decisions that align with your financial goals.
