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Hi all, Ryan here from Mortgage Choice, and today we’re going to talk about a question we get asked a lot from our customers. Ryan, what is equity? How much do I have and how do I use it? And what can I do with my equity? And if you’re new to our channel, please feel free to like and subscribe to our channel because we cover everything to do with mortgages in a simple and easy-to-understand format.
What is Home Equity?
Now, home equity is a rather simple concept. However, many people are unaware what they can do with this equity and how it can assist them into retirement and in the long run, in life. Now, utilising home equity isn’t for everyone. We would always recommend you obtain some financial advice to see if this suits your individual circumstances.
Now, I thought the easiest way to explain what home equity is is on the iPad here. Now, what I’ve done, I’ve spent a lot of time drawing this house, and I hope your house looks a bit better than my house with a yellow door. Now, in this diagram, we have a house that’s worth $1,000,000 and a loan that has a balance of $500,000. Now, home equity is a very simple concept. It’s simply the difference between your house value and your loan balance. So here in this case, your home equity is $500,000.
What can you do with Home Equity?
Now that we know what home equity is, your next question is, Ryan, what can I do with my home equity? Well, there are many things you can do with your home equity, some of which include drawing on this equity for renovations, that lovely pool you want out the back of your residence that you’ve always dreamt of investing in shares, purchasing a car, purchasing an investment property, and almost anything. Obviously, within reason! The most common use of equity we see is utilizing your equity to purchase an investment property in a bid, to start earning some passive income into retirement, or to simply wait until this property grows (we hope) then sell this property and pay off your home loan. Doesn’t that seem great? A debt-free life.
How to use equity to invest in Property
Now, I want to show you how people use home equity to purchase an investment property. We’re back here on the iPad and we’ve got two houses now. We’ve got house one from our last scenario with the yellow door, $1,000,000 value with a loan balance of $500,000. That’s what we remember from last time. Now, let’s assume you purchase another property for $500,000. And we’re going to assume that you borrow 100% of the purchase price, plus stamp duty, let’s say $25,000. That means you need to borrow $525,000. If we total up the columns, we now have a loan balance of $1,025,000. And we’ve got a security value or an asset value of $1,500,000 . That means we’re geared at 68% in terms of a loan-to-value ratio. Now, in this scenario. This is what we call an 100% debt funded investment property where you have enough equity in your property to purchase an investment property and borrow 100% of the property value plus costs. This means you don’t have to contribute a single cent to the transaction, which could be a benefit to you from a taxation perspective.
Home Equity Lending Requirements
Now, Ryan, what are the lending requirements on utilizing home equity? As a general rule, you can increase your loan up to 80% of the property’s value, right? So in our example before, if you have a $1,000,000 property with a $500,000 loan, you can increase your loan by $300,0000 to $800,0000, which is 80% of the property’s value. Now, you need to be able to afford the $800,000 loan though, even if it’s just sitting in a redraw or offset facility. This is an issue many people face where they tend to be asset rich but cannot extract the full equity of their property because of the lending restrictions out there.
Why people don't use home equity
Now, let’s talk about why people don’t use home equity. Well, lack of awareness. Some people may not be aware of the concept and how it can be used as a financial tool to assist them. The other reason is risk. Many people are risk averse. And as I said before, home equity does have its risks.
The Power of Leverage in Property
Now let’s talk about leverage. Leverage is basically the use of borrowed funds to increase the potential return of an investment. Let’s go back to the iPad to see how leverage can benefit you. So how can leverage benefit you? It’s actually pretty simple.
So back to our scenario. We are again if we have a property worth $1,000,000 and let’s forget about the debt at the moment. But if this property is growing at 4% per annum, you’re making about $40,000 at the end of day and you’re happy as Larry with that. But let’s add another property to this situation here. Assume the same growth of 4% per annum, you’re making an extra $20,000 $60,000, which equates to $60,000. And let’s add a third property in. Assume the same growth of 4% per annum, you’re making $80,000.
This is the power of leverage and it’s generally how people make money in property. Now, what you could do in 5-10 years time is sell one of these properties that you’ve purchased for $500,000 to pay off your original home loan. Depending on the growth, it might pay it off in full or it might pay a portion off. You could also sell this property that you’ve purchased for $500,000 to pay off this property, which will create some passive income in retirement. Now, this is what a lot of people are doing in the later stage of their lives to create some passive income in retirement.
So now that we know what equity is and how we can use that equity, let’s have a conversation to see if this is a strategy that you can use to start making your money work for you into retirement.
Now, that’s all from me. I hope you enjoyed our video. Our office is all about simple education. Please feel free to reach out to us. Talk to you soon. Thanks, Ryan.