Accessing property equity is not just important, it’s absolutely essential if you wish to grow your portfolio beyond more than one or two assets. Michael Beresford reveals how you can tap into your equity to fund further property purchases in an uncertain mortgage market.
As property investors, equity is constantly on our minds. If we’re not talking about it, we’re thinking about it. And if we’re not thinking about it, we get this hollow feeling inside. And for good reason too, because equity is a key weapon in the property investment armoury.
Recent Australian trends like low household income growth, house price growth and increased investor loans have shaken up the mortgage market and left in its wake uncertainty and a few challenges.
Some of the effects of this include the big four banks increasing their interest rates, mainly for investors but also because of a desire to reduce their approvals of interest-only (IO) loans, given the rapid growth in these loan types over recent years.
All of this has forced property investors to look at alternative equity strategies. Here, I’ll cover the basics of equity; discuss the loan repayment options available in this environment, and give recommendations to help you make the right mortgage choices.
What is equity?
More importantly, why should you think about accessing equity?
Equity is the difference between your home’s market value and the amount of debt you still owe the bank. For example, if your property is worth $600,000 and your mortgage stands at $350,000, your equity is $250,000.
In simple terms, your property creates equity as you pay off your mortgage and/or as its value increases. Say your $600,000 property increased its capital growth value by 10% last year. That’s $60,000 in equity. Add in any reduction you made to your mortgage during that time and that’s a significant increase, which can then be used as available funds for your next deposit.
To tap into this equity requires refinancing your mortgage at its increased value, thus freeing up some of the equity to spend on further investments. Leveraging your available equity is a great way to finance your next investment property; it’s far superior to paying off your home first and saving up for another deposit. Be sure, though, to always keep a buffer in place for peace of mind.
By using your equity to fund additional investments and putting surplus cash towards paying off your mortgage, you reduce your home loan while maximising your tax deductibility.
Ideally, you want to create a line of credit and a separate loan rather than a redraw facility, which simply increases your mortgage and adds extra debt to pay off with your post-tax salary. A separate loan means your mortgage is untouched and you get tax deductibility on your equity, since you’ve used it to reinvest.
“Leveraging your available equity to finance your next investment property is far superior to paying off your home first and saving up for another deposit”
Play your cards right and you can even live off equity. This is where the real power lies in a portfolio of several properties established over time, and diversified by location. But before we get to our recommendations, here’s a quick recap of how to work out your current equity levels. Calculating your available equity
To find out how much equity you have, you will first need to have your property valued. Your bank will engage a valuer to do this, although be aware that valuers are conservative by nature so a bank valuation may be lower than you would expect.
Note that most banks allow you to have debt of up to 80% of the value of your property. While you can access a higher amount, up to 90% (and occasionally 95%), depending on the bank’s appetite, this will mean you will have to pay lenders mortgage Insurance on the loan.
The figure of 80% is considerably less than your total equity; however, it does represent your easily accessible available equity.
It’s not advisable to use all of your available equity at one time without ensuring you retain a buffer to cover the cost of any unexpected maintenance, vacancies or a change in your personal circumstances.
Once you’ve done the maths and worked out how much equity you’re happy and able to take out and reinvest, you can then approach your bank for an equity loan. Of course, you’re not guaranteed a loan, since the bank will also consider things like age, dependants, additional debts, living expenses, income (including government payments) and rental income.
Refinancing options in the current mortgage market
Now that we’ve covered equity and how to calculate it and access it, let’s return to today’s complicated Australian mortgage market.
“Interest-only loans have become harder to obtain from the major lenders and we’ve fielded all sorts of questions from concerned investors”
It’s best not to dive into refinancing without knowing you can afford it. Be prudent and informed. Property investment is a huge financial commitment, so educate yourself before investing.
Do your market research. Make sure you’re not overextending, and speak to professional property investors if you’re lacking confidence or are unsure.
In terms of structuring your loans, the available equity of $130,000 in our example may come from your existing lender, or whichever bank gave you the $600,000 valuation, and you could borrow the remaining amount required from a different lender. This is ideal for several reasons, but especially because in today’s lending market you need to be flexible and prepared to compromise on the ideal structure, if that’s what is required to get approval.
Your equity stake covers the deposit and other purchasing costs, such as stamp duty and bank fees as well as interest during construction, if you’re building new.
But what about repayments? Interest-only loans have become harder to obtain from the major lenders and we’ve fielded all sorts of questions from concerned investors about the benefits of principal and interest (P&I) loans and the difference between the big four and second-tier lenders.
Interest-only repayments require you to repay interest and any loan fees over the period agreed upon by the lender. When the IO period (usually one to five years) expires, you must request and negotiate a new IO term. To ensure you’re not caught out, conduct thorough research well in advance to work out what your lender allows at the end of your loan. Be aware of competitor offerings also, as refinancing may be the best option, depending on your equity position.
A WORD ON BANKS
1. Second-tier lenders (or non-bank lenders) are lenders – which are most likely to be building societies or credit unions – that obtain their own wholesale funding from other sources. Many of them will secure their funds from the big banks themselves.2. Banks, building societies and credit unions, irrespective of size, are classified as ADIs (authorised deposit-taking institutions), meaning they have to adhere to the same rulebook set by APRA(the Australian Prudential Regulation Authority).
3. APRA’s control over the major banks, who provide over 80% of Australian home loans, has led to more frequent changes and a faster-paced market that has required mortgage brokers and consumers alike to spend more time researching the varying loan offerings.
4. APRA was also responsible for reducing the percentage of investment loans on the banks’ loan books and restricting annual growth of investor loans to 10% per annum. This triggered the increase in interest rates for investors and the tightening of loan servicing in the banks’ attempt to curb growth.
A P&I loan is a long-term strategy to pay off your loan over the defined term; a common time frame is 30 years. Your lender calculates your repayments, including interest and fees, plus a chunk of the principal balance. As your loan reduces, so does the interest. By making you pay off some of the loan each payment, P&I loan structures help you own the asset sooner. See it almost like a forced savings account.
At OpenCorp, where cash flow allows we recommend P&I loans for the mortgage on your own home, and interest only wherever possible for your investment loans. That said, interest only on your mortgage can be an effective strategy if it allows you to hold more property than you’d otherwise be able to if you were servicing a P&I loan.
As always, understand the different options and which one maximises your borrowing capacity and best suits your risk profile. But no matter which of the two loan options you decide on, you may find yourself rebuffed by major lenders, which is why we suggest exploring options beyond the big four.
Changing lending landscape
As a result of APRA’s influence(see boxout above) and investors’ undying appetite for real estate, more people are now opting for second-tier loans. Following are some general features of second-tier lenders to consider.
Second-tier lenders will often have a little more flexibility, which is certainly an element to consider when comparing the big four and second-tier lenders.
Part of the reason is infrastructure, or lack thereof. Unlike the big four, which have suburban bank branches in abundance, a second-tier lender will usually provide online or phone services as an alternative.
By keeping overhead costs down, the theory is that these institutions can pass this saving on to you, sometimes at even lower rates than the big four’s. There isn’t a massive downside to low overhead costs (aside from convenience), especially if you’re going through a mortgage broker who’ll manage the process for you. Importantly, these lenders are typically no less safe than the bigger banks. In fact, they can be more motivated to obtain your business, so they are worth investigating.
Interest rates and fees
Of course, this theory doesn’t always transpire, so, to state the obvious, it pays to do your research. And while you are doing so, make sure you consider another key factor: exit fees and upfront costs.
Traditionally, second-tier lenders offer very competitive mortgage interest rates but higher exit fees (sometimes as high as 1% or 2% of the original loan amount), or higher upfront fees. Make sure you read the fine print and do the right calculations.
Second-tier lenders are a great alternative if you’re not best placed to go down the traditional path. Approximately 25% of Australian borrowers have their loan applications rejected by the major banks, for all manner of reasons, such as bad credit ratings, employment uncertainty and lack of serviceability, to name a few.
The good news is that second-tier lenders are often more open to proposals, so you stand a good chance of your equity loan being approved even if it was rejected by all four major banks.
For those denied by the major banks, it is heartening to see second-tier lenders becoming more efficient at keeping interest rates low across the board. Just be aware that they may charge a higher premium (usually between 1% and 5%) should your application raise some red flags.
A true non-bank lender is one that sources its own wholesale funding and then lends out these funds, making a margin on the difference. These institutions have merit, but try to pick a transparent one that reveals as much as possible. This is to minimise the risk that the funding sources of these lenders may be cut off in the future, which would cause your interest rate to change or even your loan to be ‘on-sold’ to another lender if the non-bank goes out of business.
“You may find yourself rebuffed by major lenders, which is why we suggest exploring options beyond the big four”
In summary, it is definitely worth researching alternatives to the major banks, just as it’s important to consider options for your portfolio equity and the different types of loans you can take. Hopefully this article will help you make informed investment decisions moving forward.