Using your equity to buy a second home
As a home owner, you can use the equity in your home to buy a second property. This you can minimise or avoid saving a deposit.
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Being a homeowner with some equity in the property gives you plenty of options when looking at buying a second home or investment. If you have enough equity built up you may be able to buy another property with no deposit at all.
You can borrow against the equity in your home or refinance your loan to borrow more money. Another strategy is to save money in a home loan offset account and use that as a deposit. Using equity to buy a second home can help you purchase a second home faster. But you need to make sure you have enough equity and understand how much you could end up paying in interest by borrowing against it.
How does equity work when buying a second home?
You can buy a second home without cash for a deposit by using the home equity in your existing property.
Equity is the difference between the current value of your property and the amount you owe on it. For instance, if your home is worth $700,000 and you owe $500,000 on your home loan, you have $200,000 in equity.
Equity increases in two ways. First, you build equity by making your regular principal and interest repayments. The more you pay down the principal of your home loan, the more equity you create.
The second way equity accrues is through your home rising in value. If you paid $500,000 for your home and it's currently valued at $550,000, you would have accrued $50,000 in equity through capital growth.
Here's a more detailed example:
- You bought a property in 2015 for $500,000
- Your deposit was 20% or $100,000
- Your initial loan was therefore $400,000
- Now the property is valued at $750,000
- You've paid $50,000 off the mortgage principal by making repayments to the loan
- The total debt is now $400,000 - $50,000 = $350,000
- The total property value is $750,000
- So your equity = $400,000
Lenders will typically let you borrow up to 80% of the equity for your property to purchase a second property. So in the example above, the amount of equity you can access is actually $264,000.
Ways to finance your second home purchase
Working out your equity is one thing, but how do you actually access it? There are several ways, including refinancing your home loan, taking out a line of credit or using savings from an offset account (or elsewhere) as a deposit and taking out a new loan.
Refinancing your existing home loan is a common way to unlock your equity when buying a second property.
Let's use the example above, where you have $264,000 in equity to borrow against. You approach your current lender about refinancing in order to purchase a small unit as an investment. The unit costs $250,000.
You borrow against your equity to cover the purchase and use some of your savings to cover your stamp duty and other costs.
Your lender agrees and you apply for a new loan with them to cover your remaining mortgage and the new debt. You agree to a new loan term of 25 years.
- Note that altering your original loan and extending the loan term will likely result in you paying more in interest over the course of the loan. While refinancing, it's also worth considering if you get a lower interest rate and a better deal elsewhere.
Line of credit
Another way to unlock equity is through a home equity or line of credit loan. This is a separate loan that extends you an amount of credit based on the equity in your property. If you have a significant amount of equity in your home, a line of credit loan could potentially account for most or all of your deposit.
A line of credit loan only requires you to pay the interest portion of the loan until you reach your credit limit. You can use as much or as little of the credit limit as you like, and only pay interest on the amount you use. This can be a tax-effective strategy for investing in property, because it maximises your tax-deductible debt by allowing you to make interest-only repayments.
While a line of credit loan can help you invest in property sooner and carries significant tax advantages, there are some drawbacks. First, using a line of credit loan to invest in property could potentially see you managing three home loans. Between your owner-occupier home loan, the line of credit and an investment loan, using a line of credit for property investment can be cumbersome.
Another drawback of line of credit loans is that you're using your own home as security. This means that if you run into trouble repaying your line of credit when it's due, your lender could seek recourse through your property and, in the worst case scenario, could even foreclose on your home.
A borrower with money in their offset account has another option to fund their second property purchase.
Again let's use the example above. Your home is now worth $720,000, your original deposit was $120,000 and you've paid off $90,000 by diligently making your monthly repayments. However, you've also been putting money into the offset account attached to your home loan.
If you've put $1,000 a month in your offset over the last 8 years you've now saved $96,000 which can become the deposit on your new $400,000 investment property.
Now you need to take out a new investment loan to cover the remaining $304,000 and continue making repayments on your original home loan.
What about when you're keeping your old home as an investment and buying a new home?
The offset strategy makes even more sense if your plan is to buy a new home to live in and convert your existing home into an investment property. In this scenario you actually want the investment property (your former home) to have as much debt as possible because interest paid on an investment loan is tax deductible. Interest on a home is not.
By pulling the money out of your offset account and into your new home, your old home's loan converts to an investment loan with a larger tax deductible debt. This is only possible because of the offset account. If you'd been making extra repayments into the loan itself you wouldn't be able to pull them back out and get the same tax benefit.
Buying a new home and selling the old one
Not everyone is buying a second home as an investment, or buying a new home and keeping their existing property as an investment. Some people just want to upgrade by selling their existing home and buying a new one.
But it's hard to get the timing right. You need to find a new property to buy, find a seller for your old home, and try to time the settlement days for each so you can have the money from the sale on hand to cover the new purchase.
If you're in this second home buying scenario you have some options to make it easier for you:
- Be flexible on settlement dates. Try to be as flexible as possible with your settlement dates, and be sure to check this in advance with the people you're buying from and selling to. The longer the settlement window on your sale, the more room you have to move.
- Use offset savings. If you've made significant savings through your home loan offset account you can easily pull this cash out to form part or all of your deposit. This can let you buy a second house before you've sold the first. Just keep in mind you might get stuck paying off two mortgages if you can't sell your old home fast.
- Consider a bridging loan. Bridging loans are financial products designed specifically for people in this situation who are caught with a shortfall or gap between their sale and purchase settlement dates.
Make sure your finances are in order before buying a second home
Buying a second property is a serious decision. You may have plenty of equity to play with but you don't want to jeopardise the wealth you've built up by making a poor decision.
Here are a few steps to take in order to protect yourself.
Whether you decide to refinance, top up your existing home loan or take out a line of credit loan, you'll be making larger repayments. This will require careful budgeting to ensure you can service your loans. You need a healthy cash flow to pay back what you borrow.
If you're investing, make sure you do your research to determine how much rental income you'll be able to generate versus the expenses of managing the property and servicing your new debt.
You can use this investment property tax spreadsheet to work out the sums for the income you're likely to generate versus your expenditure. Once this is determined, budget wisely to ensure you will be able to comfortably manage any extra expenses. If your cash flow is positive, you're in a good position. However, even if your cash flow is negative, you can benefit at tax time from negative gearing concessions.
Understand the tax implications
For tax purposes, your home is considered your principal place of residence. You don't have to pay capital gains tax when selling your home. But if you own a second property you will have to pay a tax on the capital gains when you sell it.
With an investment property you can deduct many property maintenance costs from your taxable income. With a holiday home, you can only deduct expenses if you also rent out the property. Claiming deductions on a holiday home can therefore be complicated if you use the holiday home yourself but also rent it out at other times.
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