Using your home equity as leverage

Part 2 of the ‘Take Control: How Home Equity puts you in the driver’s seat’ article from the December issues of the Australian Property Investor magazine written by Monique Wakelin.

Many Australians and North Americans have something of a mental block when it comes to using the home equity in their own home as leverage to buy real estate investment property. They feel a little jittery about perceived risks to their primary source of security and shelter.

But most people who buy an investment real estate property already have a home an duse the leverage factor because it’s a ready-made “deposit”. This enables the home owner to “re-borrow” part of the equity of the home. These borrowings become a small part of a loan that’s paid back at the applicable rate, along with any other funds borrowed for the investment real estate property.

The basic principle is that home equity is the happy by-product of the initial deposit the owner put in, any principal that has been paid off and any capital gains the home has achieved.

The main benefits of using home equity to buy investment property are:

The Ability To Borrow
Up to 100% of the purchase price of the investment property plus costs. The investment property will remain the primary source of collateral for the lender, as they will generally finance 90 to 95 per cent of the value against that investment real estate property. The notion of “putting the home on the line” doesn’t apply under these circumstances.

There’s No Need To Own
Your home outright or sell it to access enough home equity for an investment real estate purchase. Wise use of this equity can put you into the wealth-creating assets much more quickly than if you wait until you own it outright.

While this strategy increases your mortgage on the home, a wisely chosen investment property will provide enough compounding growth to outstrip the cost of servicing the debt. The golden rule is for the real estate investor to focus on the quality of the asset they’ll own and not merely on what they owe the bank!

Smart investors in real estate and property categorise property borrowings in two ways: as productive debt and non-productive debt. Productive debt is used to purchase real estate assets that will grow in capital value and help contribute to financial independence. Non-productive debt is for consumable items that don’t increase in value or provide income – including cars, holidays and clothes. Non-productive debt attracts higher rates of interest as it’s usually sourced through credit cards or unsecured personal loans.

The residential property investor in real estate is using productive, tax-effective debt to make money through capital growth.

Details about home equity loans and more are found at this condominium resource website for condo owners.

Take Control: How Home Equity puts you in the driver’s seat

Real Estate Capital Growth is the sure-fire route to financial freedom through real estate property writes Monique Wakelin, but it all comes down to choosing the right assets. Part 1 published in the API magazine December 2006 issue.

If a potential real estate investor were to ask what the single most important factor was when selecting residential real estate there could be only one answer – a home property’s potential for excellent long-term capital growth.

The consistent and compounding effect of real estate capital growth is the golden goose because compounding growth produces equity in your real estate assets. It’s the ability to control more and more equity that can produce an income – the key to financial independence. Not only does capital growth, over time, provide the leverage for further investments, whether it be real estate or other, it’s locked away tax-free for as long as you own the property. Understanding the whys and wherefores of home equity and real estate capital growth are crucial if a prospective investor is to achieve the ultimate aim – financial independence through real estate investments.

Many residential property investors take the view that this asset class should be income driven. However, a higher growth property will actually deliver the better income stream over time. It’s more a question of balancing the growth potential and achieving a steady rental income rather than looking for high rental returns at the expense of the growth of the real estate investment property. During the actual years of the investment strategy, the role of rental income is to meet holding costs such as loan repayments, maintenance, insurances, rates and other outgoings.

Choosing high growth property real estate allows the investor to build equity quickly, which means they don’t need to rely on saving for another deposit from after-tax income. Compounding capital growth produces an exponential increase in value over time. If, for example, you buy a $300,000 investment property real estate that increases by an average of 10 per cent a year, then the compounding factor doubles its value every seven years, and you’ll create $1.9 million in equity over 21 years.

There can’t be too much emphasis on the fact that residential real estate property investment is a slow path to financial security and not a “get rich quick” scheme. It must be based on correct asset selection to produce consistent capital growth. But time and again, we see real estate investors making the same basic mistake, hinging on the belief that all property is good real estate property and that it must at some point increase in value. Instead, real estate investors end up with a capital loss or price stagnation and no equity to show for the years of repaying loans and funding maintenance expenses.

Only correct and specific real estate asset selection will ride out any property cycle downturns and even out the returns. Provided you’re at least five to ten years away from retirement, focusing on capital growth of real estate will allow you to accumulate some serious net home equity and built on it relatively quickly.

If we take a specific example of a well-selected property investment bought in 1980 for about $50,000 and look at its current estimated value we start to get the picture. In today’s market real estate, its value would be around $500,000. Back in 1980 that amount of money would have bought a house in the top-drawer areas of most major capital cities.

We know that over the past 26 years a number of major economic, real estate investment and political cycles have transpired and real estate property values have increased strongly in spite of booms and recessions. Anyone can purchase a real estate property that looks like it might perform well but the real aim is to purchase the ones that perform no matter the prevailing market conditions.

At its simplest level, capital growth on a property increases your equity or net worth. In other words, it’s what you actually own rather than what you owe. Good capital growth will increase equity at a faster rate than an individual could achieve simply through loan repayments or by saving cash in after-tax dollars. Top-performing residential investment property doubles in value every seven to ten years and grows in capital value by an average of 5 to 8 per cent a year ahead of prevailing inflation.

The scenario of applying for a bank loan gives us a good snapshot of how home equity in real estate is viewed from a purely financial perspective. Lenders seek security on their home loans and number one on the list is property. The highest loan to value ratio (LVR) is given against real estate property. Lenders will offer up to 100 per cent (or even more) of the purchase price against real estate properties, whereas shares will attract a maximum LVR of 80 per cent if you’re lucky.

Therefore, the higher the rate of capital growth on the home property, the greater the owner’s ability to use the accumulating equity to purchase further income-producing real estate assets. A real estate property that returns low capital growth rates makes the owner much more reliant on having to actively reduce the debt in order to create more equity. This can only be done through extra repayments off the principal mortgage out of after-tax wages or by paying off lump sums when funds become available. Home equity in real estate build-up from properly selected property will outstrip the rate at which most people can find extra dollars regularly from their own pocket.

For more information, please visit the API Magazine website or Urban Living tips and checklists for condominium living here.