Unlocking equity in your home to buy an investment property
As we pay down our mortgage and property prices increase over time, we’re developing equity in our home. Theres an asset that can be used to further increase our asset portfolio.
Say you have a home worth $1m, a mortgage of $500k and $500k equity. You’ll need to maintain at least 20% or $200k equity to satisfy 80% Loan to Value Ratio (LVR) rules for an owner occupied (OO) home leaving $300k available to use as deposit on an investment property (IP).
Then with the LVR rules set at 70% for investment property means your $300k equity could be used as 30% deposit on another $1m house, so far so good.
Where it gets a bit tricky is in servicing the $1m mortgage that would come with it. To release that equity you can either top up your existing mortgage by $300k and put it into an IP meaning you would have a $800k mortgage on your OO home and a $700k mortgage on the IP … of you could cross securitise the two properties leaving your OO home mortgage at $500k and the full $1m mortgage on the IP where there is tax deductibility on the interest, see your accountant re that.
Given interest rates are around 5% and a typical IP return is around 5% gross before rates, insurance and R & M, and rental income is typically scaled to 75% meaning the bank will allow 75% of it to be used in affordability assessments, there’s quite a bit, namely the principal, that needs to be serviced from personal income which would need to be strong to meet lending criteria.
No matter the size of the mortgage, if the interest and IP return are both around 5% to begin with then they take care of each other, then there’s just the principal amount to cover from own income which, given time has elapsed, will become a smaller and smaller portion of your income.
For example a $1m IP returning 5% would bring in around $960 week whereas the mortgage would be $1,238 week equivalent producing a $278 week shortfall, conversely a $600k IP returning 5% would be $570 week and the mortgage on it $743 week producing a $173 week shortfall. $600k will get you a smaller property in a city or major town and a larger property in the regions.
As time goes on, property values and rents increase and inflation erodes the cost of the mortgage so again you’re building equity in another property as more and more of the rent goes to paying principal and your equity escalates.
Naturally interest rates fluctuate over time as do property prices and you’ll refix the mortgage periodically to suit conditions at the time, so the above is for illustration purposes only, it does however highlight the principles at play that can develop equity over time.
