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February 26

Can You Use a Home Equity Loan for Investment Property?

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The rising popularity of serviced apartments attracts guests seeking hotel-like comforts while maintaining their privacy. To stand out among the competition and increase profitability, it’s crucial to enhance your marketing strategies for your multiple properties in town.

Investment properties offer passive income, but entry requires substantial funds. Can a home equity loan be used for this? Understanding ‘equity’ is key. For existing homeowners, accessing home equity for investment is possible through options like loan top-ups or supplementary accounts. Explore these to leverage assets for new opportunities.

 

What is equity?

Equity represents the difference between your property’s current market value and the outstanding mortgage balance. For example, if your property is valued at $800,000 and your mortgage balance is $450,000, your equity stands at $350,000. This equity accrues over time through principal and interest repayments, coupled with potential increases in the property’s market value.

As a property owner for several years, it’s likely that you’ve accumulated a substantial amount of equity. This accrued equity is a valuable asset that can be utilized for various purposes, ranging from funding home renovations to venturing into property investments. The flexibility to use this equity makes it a versatile financial resource for homeowners.

When discussing equity, it’s essential to distinguish between equity and usable equity, particularly in the context of applying for an investment loan. Usable equity is a crucial factor considered when seeking financing for investment purposes. Understanding this distinction helps you make informed decisions about leveraging your equity for specific financial goals.

 

What is usable equity?

Usable equity is the accessible portion of your home’s equity, determined by calculating 80% of the property’s current value minus the outstanding mortgage. For instance, if your home is valued at $400,000 and you owe $100,000 on your mortgage, the usable equity is calculated as follows: $400,000 x 0.8 = $320,000, and deducting the existing loan of $100,000 results in usable equity of $220,000.

To estimate your usable home equity, you can use a calculator. However, for a more precise valuation, your lender or mortgage broker may request a formal bank valuation to assess the current value of your home and determine the exact usable equity available for potential borrowing. This process ensures accuracy in evaluating your financial resources for various financial endeavors.

 

Using a Home Equity Loan to Invest in Real Estate

Usable equity, the accessible portion for borrowing, is calculated by subtracting 80% of your property’s current value from the outstanding mortgage. This figure represents the amount you can tap into for various purposes, including real estate investment.

Home equity loans provide flexibility, enabling you to utilize the proceeds as you see fit, whether for real estate investment or other financial needs. To use a home equity loan for real estate, ensure you have existing property equity, maintain good credit, and demonstrate adequate income for loan repayment.

However, having the option to use a home equity loan for real estate investment doesn’t automatically make it the best choice. Consider your financial goals, risk tolerance, and overall investment strategy before making decisions.

 

How can you use your usable equity to buy an investment property?

Utilizing the accessible equity in your home can enhance cash flow, potentially serving as a deposit for a second property. Your existing property acts as collateral for the new debt. Different methods exist to borrow against home equity for a property purchase, each carrying its own set of advantages and drawbacks.

While having sufficient equity is essential, accessing it may vary among lenders. Factors like income, age, employment, family status, and existing debts are considered, and some lenders may have restrictions on its utilization. It’s crucial to evaluate these factors when exploring options to leverage home equity for a second property.

 

  1. Home loan top up

Borrowing against your property’s equity often involves a home loan top-up, allowing an increase in your existing loan limit. This provides cash for securing an investment property, eliminating the need for a separate cash deposit. The feasibility of a home loan top-up depends on factors like loan type and repayment capacity, and it’s advisable to check with your lender about this option.

Opting for a home loan top-up requires careful consideration, as it involves additional repayments over the original loan term. Accessing equity increases the amount owed on the home loan, leading to higher repayments. It’s essential to use a repayment calculator to estimate the impact on your repayments and assess the financial implications before proceeding.

 

  1. Supplementary loan account

If you prefer not to raise your existing home loan balance, an alternative is to utilize your equity by establishing a new supplementary loan account. This option allows you to select features different from your current home loan, such as a new repayment frequency or a different type of interest rate, like a fixed rate.

When opting for a separate loan to access equity, you can choose a loan with a different term. However, be cautious as this new loan may have a longer term than your existing one, potentially extending the duration over which you pay interest on the entire loan amount.

 

  1. Cross-collateralisation

Cross-collateralisation is a strategy employed by some investors to leverage usable equity for buying an investment property. It involves using the existing property as collateral and adding it to the new investment property loan. This results in two loans: the original mortgage secured by the existing property and the new mortgage secured by both the existing and investment properties.

However, cross-collateralisation comes with potential drawbacks. It may offer less flexibility compared to other equity usage methods. Having both securities tied to one loan can create complications if you need to separate them later, such as when selling one property. This process may involve rewriting the loan for the property you’re keeping, leading to a new account number, loan contract, and bank valuation.

 

Risks of Using a Home Equity Loan to Invest in Real Estate

 

Home Equity Loan Risks

Home equity loans enable borrowing against your home’s equity with a lump-sum payout repaid over time at a fixed interest rate and monthly payments. Two primary risks accompany these loans:

  1. Defaulting on payments may lead to losing your home.
  2. Declining home value may result in being underwater on loans, restricting your ability to move or sell without paying your lenders.

 

Real Estate Investment Risks

The housing market’s future is uncertain, with a slowdown observed in 2023 due to rising interest rates. Investing in real estate during a market slowdown may pose challenges, considering closing costs, high interest payments, and potential renovation expenses.

Real estate investing, once accessible, now demands skill and specialized knowledge for market analysis, rental assessment, and calculating return on investment. Luck in a hot market doesn’t guarantee genuine success, and developing expertise takes time.

Profiting from house flipping in the current market may be challenging. For rental property investments, thorough research on the rental market and local regulations is crucial, especially considering pandemic-related eviction moratoriums.

Before using a home equity loan for investment, assess your financial capability to handle mortgage payments and potential rental income gaps. If unable to sustain payments for over a year without rental income, the risk of losing your home exists. Evaluate this risk against the potential passive income reward before opting for a home equity loan.

 

Tips for investing in property

When expanding your property portfolio, prioritize a well-thought-out investment strategy for optimal short-term and long-term returns.

 

Key considerations for property investment:

  1. Research the local market, understanding rental demand and property price trends.
  2. Manage cash flow meticulously, estimating monthly rental income and outgoing expenses, including strata, council fees, maintenance, and loan repayments.
  3. Focus on areas with solid capital growth, avoiding buying at the market’s peak to prevent negative equity and suboptimal returns.
  4. Assess the age and condition of the property, including its facilities.
  5. Factor in property maintenance requirements, considering potential costs for properties with pools or large gardens.
  6. Think like a tenant, understanding the market’s rental preferences.
  7. Evaluate the property type; while off-the-plan apartments can be risky, established properties are often considered safer investments.

 

The Rule of Four

Calculating the ideal investment property budget? Some investors follow the ‘rule of four’: multiply usable equity by four for the answer. For instance, $100,000 usable equity x 4 = $400,000 max purchase price. This rule accommodates a 20% deposit, avoiding lenders mortgage insurance (LMI) and leaving room for additional costs like stamp duty. It’s a practical approach to assess if you have a sufficient deposit and can handle upfront property purchase expenses. If the deposit is less than 20%, LMI may apply, serving as a risk mitigation tool for lenders in case of repayment challenges.

 

Interest-only or principal and interest repayments?

When considering property investments and repayment strategies, two options stand out: interest-only and principal and interest repayments. 

 

Interest-only:

Some investors opt for a supplementary home loan tailored for investment purposes. This involves a low-rate home loan with a shorter duration (4-5 years) and interest-only repayments during this period. This minimizes required repayments, potentially freeing up cash flow and leveraging market increases. At the end, you can refinance or refix the loan, deciding to keep, reinvest, or sell the property. Keep in mind, an interest-only loan doesn’t reduce the principal, leading to higher repayments when the interest-only period concludes.

 

Principal and interest:

Designed to repay the mortgage over 30 years, principal and interest repayments gradually reduce the loan balance and interest paid. This option may offer higher borrowing power and a lower interest rate. However, repayments are higher compared to interest-only, impacting cash flow if rental income doesn’t cover property expenses. On the upside, each repayment contributes to principal reduction, potentially leading to faster loan payoff.

 

Can I use a home equity loan to invest in a real estate investment trust (REIT)?

You have the flexibility to utilize the proceeds from your home equity loan for various purposes, including investing in a real estate investment trust (REIT). While REITs offer a way to diversify and reduce risks compared to individual real estate investments, recent concerns have arisen about their impact on housing markets. It’s crucial to be aware that using your home’s equity for investment purposes carries the risk of foreclosure if you struggle to repay the home equity loan.

 

Which is better for investing, a home equity loan or a home equity line of credit (HELOC)?

The choice between a home equity loan and a home equity line of credit (HELOC) depends on your investment strategy. If you plan to invest in a single property with a known amount, a home equity loan might offer a lower interest rate. However, if your investment strategy involves multiple properties over time, a HELOC provides the convenience of accessing and repaying equity multiple times with one product, eliminating the need for multiple home equity loans.

 

MORE Property blogs HERE: 

Buy To Let Defaults Surge with Rising Rates

Cashing Out of Buy To Let? Top Places to Make a Quick Sale

Buy-to-let Home Insurance UK

Why Are Buy-to-Let Mortgages Interest Only?

Is Buy-to-Let Still Profitable Today?

A Comprehensive Guide to Buy-to-Let Mortgages

First-Time Buyer’s Guide to Buy-to-Let Mortgages


Tags

Real Estate Investment Risks, Risks of Using a Home Equity Loan to Invest in Real Estate, Tips for investing in property


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