The Power of Useable Equity
How harnessing equity in your home or investment property can set you up for success and a better lifestyle.
Capital gains are the golden child of property investment and securing a properties which provide good growth are an excellent way to build wealth. With increased wealth, households are more willing to spend and the economy prospers; but how exactly can you build wealth in property and use the equity to your advantage? This article will explore some of the basic concepts of capitalising on wealth and uses some rudimentary examples to demonstrate how it works.
Properties in most developed economies tend to appreciate greatly in value over time and this is the main basis why property investment is considered to be one of the best vehicles for a safe, fruitful retirement. The land houses sit on generally becomes more and more valuable over time as population pressure grows and available land becomes more scarce. In order to use land to your advantage, an effective property investment strategy is required to build wealth and cashflow to allow you to maximise dollar returns if and when you require it. Therefore, maximising equity is one of the key factors of success for any property investor looking to use their investments to free up their future. In order to unlock the tools for this plan, we need to understand the fundamental basis of how equity can be used as a tool for growth.
“Buy land, they’re not making anymore of it” — Mark Twain
First, let’s distinguish the difference between equity and useable equity. Equity is simply the difference between the value of your property and the outstanding lending amount. However, useable equity is the amount of equity you have in your property which can be used to secure further credit. Often you will need to leave 20% in your property, hence why useable equity is lower than equity.
Suppose you bought a property in June 2010 for $448k (median house price in Auckland, June 2010), the mortgage repayments at 4% would have been roughly $395/w or $20,540 annually. Fast forward to June 2020, that same house, ceteris paribus, would be worth almost $900k and the mortgage balance would be roughly $277k, meaning you now have $623k in equity and approximately $443k of useable equity.
So, what can you do with all this pent up equity? The choice is yours. Property investors looking to expand their portfolios can use equity as a deposit for their next investment property through organic growth and lending against the security, or by renovating to add value and lending against the new value. This latter is called ‘recycling equity’, the concept is simple but to do this effectively you need to ensure the properties you acquire are suitable for this risky strategy and won’t leave you with too much debt:income which could lead to a negative gearing portfolio and stall your portfolio growth. Investors early on need to understand that property investment is fundamentally about the numbers, not the product. Yes, the property is tangible and you will have to interact with the investment in order to maximise ROI, not all properties will make a good investment so you need to focus on properties that provide sufficient growth or yield (or a mixture of both) in order to keep growing.
Useable equity is also a tool that can be used to fund a deposit on a house for someone else; perhaps you have a friend or family member looking to get on the property ladder, you can use your equity to gift to them and facilitate their purchase. It is up to you whether or not you set up an agreement for the money to be paid back, but one option is to be paid back through topping up their loan once they have built equity.
Consider the following example:
Purchase price/property value: $700k
Deposit: $140k (assume you gifted $30k of your own equity)
Loan balance: $560k (80% lending)
To get your money back, your friend can apply for a construction loan and borrow 100% for the construction. Simple renovations can be done with this loan (e.g. add a bedroom, deck etc.), and the value of the property immediately goes up. Now the equation is as follows:
Property value: $820k
Loan balance $590k ($560k mortgage, $30k construction loan)
With the extra $120k value we have added, we now have $66k of useable equity. We can top up this amount at the bank to pay off the construction loan in full and pay back the gifted money.
For someone who likes spending, whether that be on cars, boats, toys, etc. using your equity to buy these is an option that isn’t often talked about. Your equity is your money so you can do with it whatever you please, and this for some people is buying assets such as boats, cars, or even a holiday. There are a few options as to how to do this, but it could be done through topping up at the bank or possibly through a revolving credit facility. Either way, you are using the value of your property to fund the better things in life and facilitating a better lifestyle. It is important to note that either of these will result in larger repayments, but this is something that can be managed and a good mortgage broker will be able to guide you through the process and give you advice on how to structure your lending to give you this option.
In addition, using a refinance to top up money is a good way to get extra money to pay off lingering debts which you might have. For instance, if you had a $10k car loan, you could potentially refinance and top up your loan by $10k which would allow you to fully repay and cancel the car loan which has high interest rates, and consolidate the debt into a low interest payment. Although this isn’t necessarily a solution for everyone, it is a good way to put your debt under a much lower interest rate and save yourself being stung by high interest rates of credit cards, car loans, hire purchase and so on.
Regardless of what strategy you take to build your wealth, utilising the equity you have in your property is of utmost importance in order to keep growing your portfolio. Obviously there are a lot of details and considerations which need to be discussed with registered professionals about how to accurately put in place the structures mentioned above, but take away the concepts which are viable to anyone who is on or is aspiring to get on the property ladder. Effective property investment is all about building a team around you of people who are knowledgable and are working for your best interests, so start building a team of professionals and utilise the equity you have.
