What is equity?
Let's start by understanding what equity is. Equity is the difference between the current market value of your property and the outstanding balance on your mortgage.
With every mortgage repayment you make, the portion of your property that you own will increase. Additionally, although this isn’t guaranteed, the value of your home should also go up over time. Between the two, the equity you have in your home will grow, making it a valuable asset you can utilise for any number of large financial undertakings, such as a holiday, renovations, or, you guessed it, investment property.
What is useable equity?
The difference between total equity and useable equity is the portion that lenders are willing to lend against. The useable amount of equity depends on things such as the loan-to-value ratio (LVR) and the policies of the lender in question.
Not all the equity in your property may be available to you. Understanding how much useable equity you have is a vital first step when considering using equity to make investment plans.
In general, your useable equity is around 80% of your total equity. Lenders tend to favour this sort of figure to keep you from having to pay Lenders Mortgage Insurance (LMI).
What is total equity?
Total equity is the value of the portion of your property that you own. In other words, it’s your useable and non-useable equity amounts combined. This is the figure lenders use to assess your overall financial position and how much you’re able to borrow for the purpose of buying an investment property.
How much could you borrow for an investment property?
Imagine you live in a property with a market value of $500,000. Most lenders won’t allow to owe more than 80% of that figure, which is $400,000. So, if you still owe $300,000 on your home loan, then the maximum you would be able to put towards an investment property would be $100,000.
When researching equity, you may have come across the ‘rule of four’. It is a principle to prevent you from overextending yourself financially. In a nutshell, the rule is to avoid borrowing more than four times the useable equity in your home.
This helps you maintain a reasonable level of debt and avoid problems associated with owing more than you can afford to repay. In theory at least, sticking to the ‘rule of four’ should safeguard you against market volatility and other unexpected increases to your outgoings.
Final thoughts
When calculating your equity and your capacity to borrow, banks and financial institutions will consider factors such as your income, credit history, existing debt and the potential rental income you can make from any investment properties you purchase.
Understanding the concept of equity, and how much of it is available to you, can give you great insight into what you can afford to do – be that purchasing an investment property or using the money for something else.
More information is available on our investment property webpage. If you have any questions, please give our team of Home Loan Specialists a call on 133 282. Alternatively, you can always speak to your broker or pop into your local branch for a chat.