In simple terms, equity is the value of the difference between what your property is worth and how much you owe on it. If you own a home worth $500,000 and you owe $200,000, then you have equity of $300,000. Sounds simple, right? Well, that’s not always the case. Whilst real estate has plenty of advantages as an investment class, it also has one distinct disadvantage: it is not a liquid asset. This means that any wealth you have that is tied up in the real estate is not always easy to access.
Tapping into your equity is one such situation where frustration can arise. On paper, you may have plenty of equity in your portfolio – but the steps involved to actually get your hands on those funds can be complicated, costly and time-consuming.
You also have to consider the buying and selling costs associated with property trading. When you attempt to access equity in your portfolio, you could be liable for upfront costs for a whole host of fees and charges, including (but not limited to) property valuation fees, loan application and settlement fees, and lenders mortgage insurance.
In our above scenario, for instance, you have equity ‘on paper’ of $300,000. However, to access that equity, you need to either sell the home to realise the profit, or obtain new finance to unlock the equity. If you sell, you will hand over tens of thousands of dollars in real estate commission, capital gains tax and other selling costs – not to mention the fact that you will no longer hold your income-producing asset. Your equity of $300,000 could quickly dwindle to $250,000, or even less. The more effective option could therefore be to obtain new finance.
You will generally be restricted to borrow a lower value than the ‘on paper’ equity amount, such as 80%.
In this case:
- $500,000 is the new property value
- 80% of this value is $400,000
- The original loan value is $200,000
- The accessible equity is $200,000
In this situation, you would have access to around $200,000 to invest with. While still a generous amount, it is far less than the $300,000 ‘on paper’ equity you may have initially been counting on.
Of course, there are certain loan products and finance structures you can arrange that will allow you to tap into your equity at a higher level. This is why it’s so important to set up the right financial structures at the beginning of your investing career – particularly if you are rolling out an aggressive investment strategy or you have plans to renovate and develop – as it will allow you to proactively take advantage of your equity as your portfolio grows, without losing too much money along the way.
How do banks calculate the value of your useable equity?
As an investor, you may want to tap into the equity in your own home or in your investment properties at some point. Perhaps you want to access some money to fund a renovation, or you need a deposit for another property purchase. Whatever your reason for wishing to access your equity, you should be aware that lenders have specific methods and criteria for calculating the value of the equity they’re willing to let you borrow against. The first step most banks will take is to do a valuation on the property, which is usually conducted through a third party, such as ValEx.
ValEx is a property valuation and risk management platform that helps to supports national property valuation management, ensuring that valuers meet industry requirements such as reporting time frames and using correct sales data.
This means the banks don’t have to worry about managing valuers – they can defer to ValEx to manage the process on their behalf. The valuers on the ValEx panel can be on other panels as well, and usually the valuations ordered are done randomly, ensuring that the transaction is conducted at an ‘arm’s length’.
Once the valuation comes back, the lender will then use that to assess how much they are prepared to lend.
For instance, let’s say:
- The valuation comes back at $625,000
- You bought the house three years earlier for $500,000
- You obtained an 80% interestonly loan for $400,000 ($500,000 x 80%)
- You now have equity of $225,000: ($625,000–400,000)
- Of course, depending on your full financial situation, it’s unlikely that you’ll be able to borrow against all of the equity in that asset.
In this instance, because you initially borrowed at 80%, you would generally be able to ‘top up’ your loan to an 80% LVR without having to apply for lenders mortgage insurance (LMI) and paying additional associated
costs there.
At an 80% LVR, your loan against the new value would be $500,000. This means you could access up to $100,000 without paying LMI. At Real Wealth Money, we have the ability to order valuations upfront with most lenders, meaning we can calculate a new loan amount for you before we lodge the loan application. This is a massive advantage in terms of keeping your credit profile in check.
How do you access your equity?
There are many different loan products and strategies you can use to access your property equity, including a redraw facility, offset accounts, a line of credit, refinancing your full loan and getting a top up loan.
The right finance solution for you will always depend on your personal needs and your situation. This is where having an experienced broker on your side can really pa dividends.
What I can tell you is that when you’re tapping into your equity as an investor, it’s crucial that you create a clear line in terms of accounting for your investment loan versus your personal (PPOR) loan.
For this reason, my broker David Wegener at Real Wealth Money suggests: “Any additional equity setup is usually best accessed in a separate loan, split from any existing debt, so it can be easily tracked for tax purposes. Usually an interestonly standard variable split will do the trick, as running a full line of credit can be costlier and is not needed for most investors.”
Top up vs a line of credit
Top up
When you top up your loan, you’re essentially making your existing loan bigger. Think of it along the same lines as increasing the limit on your credit card: you have the same product with the same lender, so you’re simply increasing the level of debt on that particular loan.
A top up allows you to get more money out of an existing property, by revaluing the property and ‘topping up’ the existing loan facility. Again, let’s refer to our earlier scenario of a property that is now worth $625,000, up from $500,000 when you bought it. The existing loan on this property is $400,000. To top up this loan, you would approach your existing lender and apply to increase your loan facility, based on the new valuation. If all proceeds smoothly, the lender would then increase your loan to become a $500,000 mortgage.
Pros:
- If you stay within the same LVR bracket as the original loan, you won’t be required to pay further LMI. For instance, if you originally had an 85% lend against a $500,000 value, you could top this up to an 85% lend against $625,000, and no additional LMI is generally payable.
- You don’t have to apply again with a new lender; all of your details and documents are on file. Note that you may need to supply some updated financials, such as tax returns or pay slips.
- No new account establishment or account keeping fees.
Cons:
Your repayments on your loan will increase in line with your top up, but there is no clear division on paper between your previous loan repayments and the value of the top up loan amount. If you are topping up a personal PPOR loan and using the funds for investment purposes, this could create some problems for the purposes of tax management.
In most instances, a top up loan is the easiest and most effective way to proceed if you wish to access equity in your portfolio.
Line of credit
A line of credit (LOC) is similar to having a giant credit card limit, where interest accrues only on the outstanding balance. Let’s say you have a line of credit for $200,000; if you use $50,000 of this LOC for a property deposit, then you only pay interest on that outstanding amount. If you then use a further $40,000 to fund a property renovation, then you will be required to pay interest on $90,000.
Pros:
These are very flexible loan products that allow you to access funds quickly and easily, without needing to apply for a new loan. Depending on your loan and strategy, you may be able to pay your loan interest payments using your line of credit; this is only suitable in certain situations, such as when you are developing or substantially renovating to add a lot of value. You only pay interest on the outstanding balance.
Cons:
A line of credit is a specialised loan product and as a result, it often comes at a premium. You will generally pay a higher interest rate for an LOC than you would on a standard variable loan, as you hand over extra money for the privilege of flexibility.
An LOC can be secured against equity across your portfolio, or against a particular property. Generally speaking, if you wish to access the equity in your portfolio, lines of credit are not necessary, unless you are running a real estate business and you are making daily transactions against the loan.
For most investors, a simple standard variable mortgage with interest-only payments is ideal; you will usually only need to access the funds when you are ready to use them.
What are the traps you need to watch out for when accessing equity?
As with all investment strategies, there are risks that you need to consider when you start tapping into equity in your loan. The biggest risk you face is the potential of overextending yourself, if you tap out too much equity and the property’s value growth stalls. This became a big issue for some investors during the GFC, when many property owners ended up in a position of negative equity.
For this reason, and especially for new investors, I would suggest keeping a conservative LVR in place of a maximum of 80%, to ensure that you’re leaving enough equity in the home to withstand market fluctuations. I’m also a huge advocate for keeping a buffer in place, so if your circumstances change for any reason, you won’t end up in a position where you are falling short financially on making your repayments.
Lastly, I think it’s important for all investors to consider asset protection as you progress on your property journey. Investors often make the mistake of thinking about asset protection after they’ve begun building their portfolio, but effective asset protection starts at the very beginning, when setting up your financial structures.
With the right systems and structures in place, you can plan ahead for situations such as tapping into equity and engineer your financial situation to be able to maximise your profits and minimise your risks. Working with a trusted mortgage broker, accountant and
property wealth coach will give you the edge and ensure you take advantage of every opportunity, while building your wealth safely and effectively.
Helen Collier-Kogtevs is director with Real Wealth Australia and a prolific property investor owning several properties worth millions of dollars
This article was published in the June 2014 edition of Your Investment Property magazine. You can subscribe to the magazine here.
