How does equity work when buying a second home?

What is equity in a property?

Equity is the difference between the current value of your property and the amount you owe on it. You can buy a second home by using the home equity in your existing property to cover the deposit or the whole purchase amount (depending on how much equity you have). You can do this by borrowing against the equity in your property.

Being a homeowner with some equity in you property gives you plenty of options when looking at buying a second home or investment. But be aware that using your equity in this way does come with risks.

How does equity work when buying a second home?

If your home is worth $500,000 and you owe $200,000 on your home loan, you have $300,000 in equity.

Equity increases in two ways.

1. Making repayments. You build equity as you pay off your loan balance.
2. Capital growth. You build equity if the property grows in value.

Lenders let you borrow against the equity you've built in your property. You can use this equity to buy a second home or investment property.

But lenders won't let you borrow 100% of your equity. You can borrow up to 80% of your equity.

Calculating your usable equity

1. Find your property's current market value. You can estimate this, or get a real estate agent or valuer to give you an appraisal. It might be valuable to get more than one type of valuation as they may differ.
2. Once you have an idea of the property's estimated sale price, calculate 80% of the current market value.
3. Minus your remaining loan amount from this 80% figure.

Example

Let's say your home is worth $900,000, and you have $500,000 left on the mortgage. This gives you $400,000 in equity.

But your usable equity is much less. 80% of $900,000 equals $720,000. And $720,000 minus $500,000 leaves you with usable equity of $220,000.

This means you could potentially borrow $220,000 to purchase a second home.

4 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:

1. Refinancing your home loan.
2. Taking out a line of credit.
3. Using savings from an offset account as a deposit.
4. Cross-collateralisation

Refinancing

Refinancing means getting a new home loan. You could get a new 30-year home loan and borrow extra using your equity. You can then use this money to buy a second home.

Keep in mind that by doing this you will pay more interest because you're signing up for a new loan, and borrowing money that you've already repaid. Understand that the bank will lend on the value of your second property, so usually there will be an equity loan from your first property (20%) and then the remaining 80% lent to complete the purchase.

And depending on the cost of the second property, plus your stamp duty costs and other expenses, you may not have enough equity to cover the entire purchase.

Line of credit

A line of credit loan lets you access some of your home equity, up to an agreed 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.

Repayments are interest-only at first, which offers tax benefits for investors. But there are some drawbacks:

• Using a line of credit loan to invest in property could potentially see you managing multiple home loans: your owner-occupier home loan, the line of credit, and possibly an investment loan if your equity can't cover the whole purchase.
• The interest rates can be higher than standard home loan rates.
• Because you don't have to repay the loan immediately while the interest accrues to the limit of the line of credit, you'll ultimately pay more in interest.

Offset savings

Some borrowers make extra repayments off their home loan to build equity faster. But if your loan has an offset account you have another option.

You can put money in your offset account and build up savings over time. While the money is in your offset, it acts like an extra repayment and reduces your overall interest charges.

If the second property is an investment property, the debt is tax deductible (good debt) whereas the debt on your owner occupied property is not (bad debt). Ideally, you want to pay down the bad debt first, as there are tax benefits on your repayments for 'bad debt'.

When you're ready to buy a second property you can easily take the money out of the offset and cover the deposit or other costs.

Using your redraw facility

If your loan doesn't have an offset account but does have a redraw facility, you can access extra repayments you've made on the loan. This is another way you can access your equity.

Redraw facilities tend to have more restrictions than an offset account, such as redraw fees or limits.

Cross-collateralisation

Cross-collateralisation means using more than one property as security for multiple loans. For example, you could have a mortgage on your home, build equity in the property and then use this as security for a second loan for an investment property.

Cross-collateralisation is a risky strategy for investors. If you can't repay the investment loan, your lender could potentially force you to sell your home to recover the debt. The 2 properties are tied together in the lender's eyes. Note that some lenders will allow you to have 2 or 3 separate loans over 2 properties, but not cross securitise them.

But for a well-prepared investor, cross-collateralisation is a way to grow your property portfolio without applying for multiple loans with multiple lenders.

Risks of using your equity to buy a second property

Equity is wealth you've built up in your property. While borrowing against this equity can be a savvy investment strategy, there are risks.

Borrowing against your equity effectively means taking on more debt or extending your existing loan. This means you pay more interest. If you've been making progress on your mortgage for many years, borrowing against your equity means you're undoing that progress.

You should also understand that investing in property is a risk. Property prices don't always rise, and sometimes it can be hard to find tenants. Your property could get damaged, or unforeseen circumstances could force you to sell the property.

It's a really good idea to get the advice of a mortgage broker to structure your loan (or loans) and an accountant to maximise your tax deductions effectively.

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. Bridging loans can be very expensive if they need to be extended.

Finder survey: If Australians have multiple investment loans, are they all with the same lender?

Make sure your finances are in order before buying a second home

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.

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.

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.

Understanding 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.

Need more help? Talk to a mortgage broker

Why you can trust Finder's home loan experts

Frequently asked questions about equity in a property

• How does equity work when buying a second home?

  You can buy a second home without cash for a deposit by using the equity in your existing property.

  Equity explained
  Equity is the value of your property minus any debts (such as your remaining mortgage debt). For instance, if your home is valued at $750,000 and you owe $500,000 on the loan, you have built up $250,000 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 $650,000 for your home and it's currently valued at $700,000, you would have accrued $50,000 in equity through capital growth.

  Here's a more detailed example:

  You bought a property in 2012 for $600,000
  Your deposit was 20% or $120,000
  Now the property is valued $720,000
  You've paid a further $90,000 off the mortgage principal by making repayments to the loan
  Your equity = $330,000
  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."

• 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.

John is the co-host of the this is money and this is property podcasts (formerly my millennial money and my millennial property). He is Director at SOLVERE Wealth, Director/Buyers Agent at Envisage Property, and is property coach of over 25 years.