Promoted by Loans.com.au
In the last 10 years since Loans.com.au launched, one thing I have come to realize is that not all customers are the same – they have different financial situations and different investment plans. However, one thing I get asked a lot is common questions about how equity works. Questions such as, what is equity, how to use equity (or unlock equity) and how can I use equity to become an investor real estate.
In this article, I hope to help you find out what equity is, how it can grow, and how I have seen borrowers use it to purchase a investment property. These scenarios are common scenarios, but by putting in a disclaimer everyone is different, and it is a good idea to consider your options and what is right for your personal situation before taking decisions.
In accounting terms, Equity = Assets – Liabilities.
In the context of a home loan, equity is the value of your property (the assets) minus the value of any outstanding loans on your property (the liabilities).
Here is an example to demonstrate:
Your property is worth $ 800,000
Your loan balance is $ 500,000.
Equity = Property Value – Loan Balance
In this example:
800,000 – 500,000 = $ 300,000 in equity
When buying a home for the first time, it's simple to calculate equity using the formula above. You simply take the purchase price minus your loan balance at the time of settlement. This will quickly calculate the equity in your home or investment property. At this point your deposit amount is different and equal to the equity value.
However, after you've had your loan for a few years, how do you recalculate your equity? Before doing this, it is important to understand how a borrower can increase their home equity over time. The value of a property's equity can increase in a number of ways.
Increase in equity Scenario 1: Reduce your loan balance to increase equity
A common way to increase equity is to pay off your loan balance. Simply put, the more principal you pay on your loan, the lower the loan balance will be. According to the above formula, the lower the loan balance relative to the property's value, the higher the home equity.
There are a number of ways that clients can pay off their loan balances.
1. Repayment of principal and interest
If you choose to repay your loan through principal and interest payments (P&I), your lender will calculate the minimum loan amount owed each month. The interest goes to the lender, but the main part goes directly to reducing your mortgage balance. Regular payments are calculated so that at the end of the loan term (typically 25-30 years) your entire loan balance is paid off.
2. Make additional loan repayments
There are strategies borrowers can use to pay more than the minimum principal due. This will allow the borrower to pay off their loan sooner and increase their home equity.
Some borrowers may choose to make a larger regular repayment, and over time this will build up over several years and become the equity in your loan. Likewise, we have other borrowers who choose to make regular lump sum repayments as well if they find they are receiving more money on an ad hoc basis.
Another loan repayment strategy that is popular for some real estate investors is to pay every two weeks instead of monthly. By making bi-monthly repayments over 26 fortnights, the borrower will effectively make the equivalent of one additional repayment per year.
3. Using an Offset Account
On Loans.com.au, some of our clients have a clearing sub-account with their investment loan. A counterpart account is a sub-account linked to the loan account. Our borrowers can have their salary and other income deposited into this account and they can pay their expenses either by transferring, BPAY, or by using their Visa debit card which is attached to the account.
The advantage of placing funds in a Clearing Sub-Account is that this money is taken into account when calculating your interest repayments. Less interest is charged to the customer because the interest is calculated on the loan balance minus the offsetting balance. The result is that any interest saved is an amount we call the "compensatory benefit" – it allows you to pay off the loan sooner.
loans.com.au has a great offset calculator to play with if you want to learn more about it.
Increase in equity Scenario 2: Increase in property prices and equity
Besides paying off your loan balance to increase equity, the other way equity can increase is if the value of the underlying property increases. According to the previous formula, any increase in the price of the property will therefore increase the equity in the home.
There are many reasons why a property can increase in value. For example, by holding the property for a long time, market conditions in the suburbs may change and all property prices in your area may generally increase. This can impact the value of your property as your area becomes more and more in demand. What you bought a property for a few years ago and what you can sell it for now could be this increase.
You can also help increase the price of the property by undertaking improvements to the property to increase its value. You can make improvements to the property such as kitchen or bathroom renovations, renovation, patio extensions or a new swimming pool, etc. It is important before you undertake any work on your property that you understand the costs and whether that cost will add capital value to your property. This research should be done with the help of local contractors and real estate agents before proceeding.
More often than not, we find that equity is increased by the combination of the two: paying off their loan and increasing real estate prices. This is usually done over a longer period.
Once you know how much equity you have available, you may want to find a way to access that equity to invest in your next property. We see our customers doing it in different ways. I've listed three common scenarios we see with our customers, but this list is by no means exhaustive.
1. The borrower sells his house
The simplest scenario is for a client to sell their house, pay off their mortgage balance, and keep the equity in cash. This money they will use to buy their next property. This is a common strategy for homeowners. However, investors may seek to downsize their home as an owner-occupier and use the remaining equity to purchase investment property with a source of income.
2. Borrow more money
In another scenario, a customer may increase their loan amount from their current lender. This will involve applying for a home loan for an additional loan amount and will likely require up-to-date information on your income and expenses. An appraisal process will take place so that the lender can determine if they can lend you the additional money. The lender will assess the property to make sure the value has increased. The extra money is then used to purchase an investment property.
3. The Borrower Refinances
In a third scenario, a borrower can completely refinance their loan and switch to another lender. They will go through a full home loan application process and the lender will assess the property. The new loan is a way to unlock the equity in the home to use as a deposit to buy the investment property. The new loan will pay off the loan with the existing lender and the client can use the extra money from the new loan to purchase their investment property.
Once you understand what equity is, there are many ways you can use it to purchase investment property. It will depend on your personal situation. In all of the above scenarios, especially when it comes to increasing your loan balance or refinancing, it is best to get advice and evaluate costs and its viability depending on your personal situation.
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Marie Mortime r is the Managing Director of Loans.com.au, one of Australia's largest online lenders. Since Marie started the business 10 years ago, Marie has made Loans.com.au into a business with $ 6 billion in home and auto loans. Marie is dedicated to improving financial literacy for all Australians and is passionate about the FinTech industry in Australia. When she's not at work, she enjoys spending time with her husband and two young children.
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