What is equity? In short, it is the difference between the value of a property and the amount of any loan over that property.
For example, if a property is valued at $400,000, and that property has a mortgage with $100,000 left to pay on it (excluding interest and fees), then the amount of equity in that property is the difference between those two amounts. In this example, the equity would be $300,000. However, to be able to access that equity, it’s important to first understand what goes into a bank’s decision to offer a home loan. It’s also crucial to understand the difference between equity and useable equity – as you generally can’t use all of your overall equity.
Calculating useable equity for your investment property
When you apply to borrow money from a bank or other financial institution, they typically look at several factors. One is the LVR (loan to value ratio) in relation to the property, or in other words the percentage of the property’s value you want to borrow. In the example above, the LVR is currently 25%. Traditionally, a bank will lend up to 80% LVR on the value of your property minus the debt owing, provided it thinks you can meet the repayments. In our example above, the breakdown would be:
⇒Property value: $400,000
⇒80% LVR: $320,000
⇒Debt owing: $100,000
⇒An LVR of 80%, minus the debt owing, equals $220,000 of useable equity.
Once you know how much useable equity you have, you can roughly calculate the purchase price you can consider for an investment property. One place to start is NAB’s ‘Rule of Four’, which is the rule of thumb to multiply your useable equity by four to arrive at the answer. In our example above that would be $880,000. NAB recommends the rule of four and not five to allow for additional costs such as stamp duty and legal fees, which it says are usually around 5% of the purchase price.
It’s also worth noting that it may be possible to borrow more than 80% if you pay for Lenders Mortgage Insurance (LMI).
To really get an up-to-date snapshot of where you stand, you could get a valuation of your current property. However, keep in mind the above calculation is a rule of thumb, and not a guarantee. The amount your financial institution may be willing to lend you will depend on a number of factors.
The bank will also analyse the ability of any would-be borrowers to pay back the debt, including by looking at income such as wages and rent. This serviceability criteria that the bank requires the borrower to meet takes into consideration the homeowner’s other financial obligations such as credit cards, car loans, other mortgages.
A lender’s serviceability criteria can change from time to time, depending on factors like its internal risk assessment policies and the state of the market.
Can you boost your equity?
If you are looking to increase the equity of your property, there may be a few things you could consider doing to help increase its market value. Typically, these are by way of renovations or landscaping (adding value).
For example: My area of specialty is in property development, and I recently purchased a three-bedroom, one-bathroom brick home with a pool and single lock-up garage in the Sunshine Coast hinterlands for $320,000. Using a pre-existing concrete slab, I was able to add value by building a one-bedroom granny flat. I also closed in the garage to the house to create a fourth bedroom and added a double carport out the front. All of this cost $100,000, increased the potential rental income of the property by several hundred dollars a week, and the property was revalued at $570,000. Do keep in mind, however, that not all renovations may add value, so it pays to do your research first.
Another way you may be able to increase your equity is to reduce the amount of debt on your property and pay it down as quickly as you can. Having any investment income from the property going straight onto the home loan can be a great way to reduce the balance of the loan and increase your equity for future purchases. This could also reduce your interest payments over time.
Over time, property in most parts of Australia has tended to increase in value, which may help grow your equity. If the value of your property increases, your increased equity may help you to access a home loan that will enable you to increase the size of your property portfolio. If your useable equity goes up it could enable you to borrow more as the amount of security you can offer increases, but it’s important to note that this isn’t necessarily true for everyone.
The property market can be volatile, so it’s a good idea to speak to a financial expert and take your individual circumstances into consideration.
Using equity during the COVID-19 pandemic
Perhaps the biggest restriction the COVID-19 pandemic has created in the home loan market is in many banks’ willingness to lend money, as many people’s salaries have been impacted and the risk of properties declining in value is widely seen as higher than it was before. That said, it largely hinges on which area of Australia you are purchasing in, the price point of your property, and whether it’s commercial or residential.
A potential positive about buying in this current climate if you can afford to do so is that you may be able to purchase property at a lower price. Then, if the market bounces back after COVID, your property may increase in value which, in turn, would create more equity in your property.
With ups, there are also downs – and one possible downside about using your equity during COVID is that if you buy a home in a market that is decreasing, then that equity could quickly erode should your property fall in value. If you are considering purchasing property during the pandemic, it is a good idea to consider the financial risks that this can involve, including whether you would be able to afford to hold your portfolio even if rental incomes decline or the equity you have built up over time reduces.
Some key considerations before purchasing an investment property
Before you choose to expand your property portfolio, make sure you have your finances in order. This includes asking yourself a number of questions to determine what your maximum purchase price is and how much you will need in rental income to make the investment sustainable. For example, you could consider asking yourself:
- If I needed to drop the rent, could the rent still service the loan?
- When property is in high demand, what is the highest amount of rent I can achieve?
- If a tenant (commercial or residential) stops paying the rent or leaves at the end of their tenancy, can I afford to make the mortgage repayments while I try to find a new tenant?
I find a lot of people can have some fear when wanting to invest in property. Not the fear of buying an investment property, but the very rational worry of how they will service the loan if things go pear-shaped. These are very understandable concerns and these decisions shouldn’t be taken lightly, particularly in the current economic climate. Currently, we’re in a volatile market, which is why it is a good idea to really know your numbers before you buy.
About Tamara Wrigley
Tamara Wrigley has been a property developer for more than 23 years and is the co-owner of Carolans First National Real Estate Nambour, one of the Sunshine Coast region’s largest agencies. Tamara purchased her first property at the age of 21 and now has a portfolio of over 30 properties.
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