Leveraging investment property equity

via domain.com.au

Have you ever wondered how property investors seem to keep buying properties without saving up for years to put down a deposit? It’s because they’re using a tactic called leverage: using the equity generated by the rising value of an existing property to purchase a new one. This property then grows in value, allowing the investor to repeat the process and buy again.

Sounds good in theory, but is it all it’s cracked up to be?

How leverage works

Leverage is a simple concept. It’s borrowing to increase the potential return of an investment. Taking out a mortgage to buy a home is a form of leverage.

Leveraging the equity in an existing property – whether a home or an investment – depends on the value of that property growing while the size of the mortgage reduces or stays the same. For example:

• You buy a property for $400,000, putting down a 20 per cent deposit ($80,000) and borrowing the remaining 80 per cent ($320,000)
• Over time, the property increases in value by $100,000. The 80 per cent mortgage would now only be 64 per cent of the property value – or less if you’re paying off the principal as well as the interest.
• You refinance, increasing your mortgage up to 80 per cent of $500,000. You create a cash pool of $80,000, which can be used as a deposit to buy an investment property

Property investor and mortgage broker Jane Slack-Smith of Investors Choice Mortgages highlights a number of benefits to this strategy.

“Using equity in this way minimises risk by keeping your cash in your pocket – you’re not using your cash reserves,” says Slack-Smith. “It also takes a long time to save cash – say, five years to save $100,000. In that time, property values are likely to increase faster than the interest on your savings.

“By using equity in an existing property, you can get into the market today and buy at today’s prices, benefiting from the coming years’ growth.”

Risky business?

There are risks to leveraging equity to buy investment properties. First and foremost, you have to be certain that you can service all the mortgages you’re taking out, otherwise you could lose some or all of your assets. Researching potential purchases thoroughly is essential to avoiding a bad investment, says Slack-Smith.

“Leveraging equity doesn’t relinquish you of the responsibility of researching before buying an investment property. You should ensure that you have a clear strategy – flipping or buying to hold – as well as ensure you’re buying in a good suburb.”

You could also end up being plagued by cross-collateralisation if you’re not careful. This is where lenders use equity in more than one property to secure the loan. While it may allow you to borrow more in the short term, in the long term it could hinder your empire-building plans.

“Cross-collateralisation reduces your flexibility. If you want to draw out equity from an investment property in a few years, it means the bank may refinance your entire portfolio, rather than just one property.”

Depending on how individual property values have changed, that could mean you’d be unable to access any equity. While cross-collateralised loans can be disentangled, it can take up to six months.

Plan of attack

It’s essential that you plan ahead before you start refinancing. A good mortgage broker should be able to help you with this process.

“It’s important to have a clear initial plan of how you’re going to set out your finances. If you plan to buy two properties, ensure you have enough equity to cover the deposit, stamp duty and buyer’s agent fees for both purchases.”

Slack-Smith recommends setting up individual loan splits against your first property that will only be used to finance the purchasing of further properties. The interest on those splits should also be tax-deductible, as long as those splits are only used for investment purposes. She also recommends setting up the splits as lines of credit, rather than as a conventional mortgage.

“A line of credit is usually a little bit more expensive, but it’s like a big credit card – you don’t pay for what you don’t use. Just be disciplined and don’t use them to finance new cars or holidays!”

Leveraging equity growth in your existing properties can help you build a property empire faster – as long as you set it up correctly from day one and do your research. Otherwise, you could find your portfolio collapsing faster than a house of cards.