While using equity to buy an investment property is a simple idea for many seasoned investors it is a question I have been asked a lot over the years by many first time potential investors. So I will discuss why investors use equity and how unlocking equity can be done in two ways, by cross collateralisation or by the stand alone security method.
Using equity in other properties is not essential when purchasing an investment property. If you don’t have owner occupied or other non deductible debts then contributing a cash deposit if you have one can make sense. This will reduce the holding costs of your investment property which can be ideal for investors looking to acquire properties that provide a positive cash flow (from the outset). That said many investors would still choose not to do this as they deem that there are better uses for their available cash. There is an opportunity cost in tying up your money as a deposit when the banks money can be used instead is the rationale. Which way to go in this regard is a personal decision and one which a financial planner would be more qualified to answer.
For most of us mere mortals who have non deductible debt the idea of tipping in cash / a saved up deposit for an investment purchase makes little sense. The perceived wisdom is your funds would be better served paying down your personal debts first. A common strategy is to pay down personal debts and then re-borrow to assist in the purchase of an investment. Thus turning non deductible debt into tax deductible debt. You may as well maximise the tax deductibility of your investment if you can right? For this reason most investors in these scenarios choose to use equity to help fund their investment property purchases.
When looking to acquire an investment property a lender will not want to lend you the full amount of the property’s value and the associated purchase costs without you either providing additional security for their loan or contributing a sufficiently large deposit. Assuming you are not using a cash deposit from savings your only alternative is then to access your equity.
As mentioned there are two main ways to access equity in your properties to assist with the acquisition of additional properties. Cross collateralising (x-coll, crossing, crossed, shared collateral) and stand alone securities.
The most common method although possibly not the most ideal is via cross collateralisation. Perhaps the best way to illustrate this method is via an example. Say you currently have a loan of $300,000 and your property is worth $600,000 and you want to purchase an investment property for $400,000.
Using cross collateralisation you could take a loan of $420,000 to cover the purchase price of the investment property as well as the associated costs such as stamp duty. Your chosen lender would have the security for the new loan noted as both the new property and your existing property. So in the end you and the bank would have an overall position of $720,000 in loans secured by $1,000,000 worth of property. This results is a loan to value ratio (LVR) of 72% which is acceptable to most lenders.
Stand alone method. Using the above example an alternative way to structure these loans and use your equity would be as follows. Borrow 80% against the new investment property ($320,000) and raise a new loan against your existing property for the additional funds required to settle. In this case it $100,000. So you are still borrowing the same amount in total however the security properties are not “crossed” together.
We usually favour the stand alone method. Stay tuned for our reasons why in next week’s post.
Regards,
Marty McDonald