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In the last 10 years since launching loans.com.au, one thing I have come to realise is that not all customers are the same - they have different financial situations and different investment plans. However, one thing I do get asked a lot is common questions about how equity works. Questions like, what is equity, how do I use equity (or unlock equity) and how can I use equity to become a property investor.
In this article, I will hopefully help you learn what equity is, how it can grow and how I’ve seen borrowers use it to buy an investment property. These scenarios are common scenarios, but putting a disclaimer in, everybody is different, and it is a good idea to look at your options and what is right for your own personal situation before you make any decisions.
How to define equity
In accounting terms, Equity = Assets – Liabilities.
In the context of a home loan, equity is the value of your property (the asset) less the value of any outstanding loans on your property (the liability).
Here’s 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 Equity
How does equity increase?
When you first buy a house, it is straightforward to calculate equity using the formula above. You simply take the purchase price less your loan balance at settlement. This will quickly calculate the equity you have in your home or investment property. At this point in time, 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 you do this, it is important to understand how a borrower can increase equity in their property over time. The value of equity in a property can increase in a couple of ways.
Increasing Equity Scenario 1: Reducing Your Loan Balance to Increase Equity
One common way to increase equity is to pay down your loan balance. Put simply, the more principal that you pay into your loan, the lower the loan balance will be. As per the formula above, the lower the loan balance against the property value, the higher the equity in the home.
There are a few different ways that customers pay down their loan balance.
1. Making Principal and Interest Repayments
If you choose to pay your loan via Principal and Interest (P&I) repayments, your lender will calculate the minimum loan amount that is due each month. The interest goes to the lender, but the principal portion goes directly to reducing your home loan balance. The regular payments are calculated so that at the end of the loan term (usually 25 to 30 years) your entire loan balance is repaid.
2. Making extra loan repayments
There are strategies that borrowers can use to pay more than the minimum principal amount due. This will allow the borrower to pay their loan off sooner and increase equity in their home.
Some borrowers might choose to make a bigger regular repayment and over time this will add up over several years and become equity in your loan. Likewise, we have other borrowers who choose to make a regular lump sum repayment as well if they find they receive more cash on an ad hoc basis.
Another loan repayment strategy that is popular for some property investors is to pay fortnightly instead of monthly. By making fortnightly repayments over 26 fortnights, the borrower will be effectively making the equivalent of one extra repayment per year.
3. Using an offset account
At loans.com.au, some of our customers have an Offset Sub-Account with their investment loan. An offset account is a sub-account that is linked to the loan account. Our borrowers can have their pay and other income deposited into this account and they can pay their expenses either by transferring, BPAY, or using their visa debit card which is attached to the account.
The benefit of putting funds into an offset sub-account is that this money is considered when calculating your interest repayments. Less interest is charged to the customer because the interest is calculated on the loan balance less the offset balance. The result is that any interest saved is an amount we call the ‘Offset Benefit’ - it allows you to pay down the loan sooner.
loans.com.au has a really good offset calculator to play with if you want to know more about this.
Increasing Equity Scenario 2: Increasing Property Prices and Equity
As well as paying your loan balance down to increase equity, the other way that equity can increase is if the underlying property goes up in value. As per the earlier formula, any increase in the property price will therefore increase the equity in the home.
There are several reasons that a property can increase in value. For example, by holding the property for a long period of time, market conditions in the suburb might change and all prices of property in your area may increase across the board. This can impact the value of your property as your area becomes more in demand. What you purchased a property for a few years ago and what you can sell it for now might be that increase.
You can also assist the increase in property price by undertaking improvements to the property to increase its value. You might make improvements to the property such as kitchen or bathroom renovations, a renovation, deck extensions or a new pool, etc. It is important before you undertake any work on your property, that you understand the costs and if that cost will add any capital value to your property. This research should be done with the help of local contractors and real estate agents before proceeding.
Unlocking your equity
Most commonly, we find equity is increased by the combination of both – paying down their loan and increasing property prices. This is usually done over a longer period of time.
Once you know how much equity you have, you may want to find a way to access that equity to invest in your next property. We see our customers do this a few different ways. I’ve listed three common scenarios that we see with our customers, but this list is by no means exhaustive.
1. Borrower sells their home
The simplest scenario is that a customer will sell their home, pay off their mortgage balance and keep the equity in the form of cash. That cash which they will use to purchase their next property. This is a common strategy for owner-occupiers. However, investors may look to downsize their owner-occupier home and use the remaining equity to buy an investment property with a revenue stream.
2. Borrow more money
In another scenario, a customer may increase their loan amount with their current lender. This will involve a home loan application for an additional loan amount and is likely to require updated information about your income and expenses. An assessment process will take place so the lender can determine if they can lend you the extra money. The lender will value the property to ensure that the value has increased. The additional money is then used to purchase an investment property.
3. Borrower refinances
In a third scenario, a borrower may refinance their loan completely and move to another lender. They will go through a full home loan application process and the lender will value the property. The new loan is a way to unlock equity in the home to use as a deposit to purchase the investment property. The new loan will pay out the loan with the existing lender and the customer can use the additional money from the new loan to purchase their investment property.
Once you understand what equity is, there are many ways to use it to buy an investment property. It will depend on your own personal situation. In all the above scenarios, particularly when it comes to increasing your loan balance or refinancing, it is best to get advice and weigh up the costs and whether it is viable depending on your own personal circumstance.
Marie Mortimer is Managing Director of loans.com.au, one of Australia's largest online lenders. Since Marie started the business 10 years ago, Marie has grown loans.com.au into a company with $6 billion worth of home and car loans. Marie is dedicated to improving financial literacy for all Australians and is passionate about the FinTech industry in Australia. When she isn't at work, she loves to spend time with her husband and two young children.
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