Buying a 2nd home: How does its equity work?

Equity is the difference between what you owe and what you own. It’s the difference between your mortgage, credit card debt and other loans. You can use your home’s equity to cover your debts and other financial obligations, buy another home, or pay off loans.

If you own your home outright and not through a mortgage, then your equity is the amount that you can use to buy a new house or pay off your existing mortgage.

If you have a mortgage on your home, then your equity is how much money you can borrow from lenders.

Buying a second home can be a great investment, but it’s important to understand how all of these financial factors work when you buy a second home. Let’s look into it.

Access your property’s equity

Let’s say Samantha bought a house for $500,000 with a 20 per cent deposit ($100,000 from savings) and a $400,000 home loan. At this point, their equity in the property is $100,000.

Over 10 years, she has paid $150,000 off the home loan’s principal. She’ll have $250,000 as outstanding debt, while the property’s value increased to $550,000.

To calculate her equity, you deduct the current loan balance ($250,000) from the current value of the property ($550,000). This gives Samantha $300,000 in equity.

Before we get into the buying process, there are a few ways Samantha can access her property’s equity and use it to buy her second home.

Refinance: Refinancing is the process of taking out a new mortgage on the property and paying off the existing mortgage balance. This allows you to keep your equity in the property, reduce the size of your monthly payments and save money over time.

Line of credit: It is a loan where the lender gives you a set level of credit based on the equity of your current property. You can withdraw as needed and only be charged for the amount you’ve used. This means you don’t actually need to sell the property in order to pay off the loan, but the fees and charges involved with this type of financing can be more expensive than a traditional loan.

Cross collateralisation: This is a type of loan that uses the equity of one home as security for loans on multiple properties. If you can’t repay one loan, you could possibly lose more than one property through liquidation, which makes it a high-risk strategy.

It’s important to know what kind of loan you have on your current property so that you do the right financial strategy for the second home and the transaction will go through smoothly.

How much equity do you need to buy a second home?

Lenders will generally allow you to loan up to 80 per cent of the property’s equity, minus its outstanding debt.

To buy a second property, calculating the loan-to-value ratio will help you determine how much you can actually use from your equity.

Going back to the situation earlier, if 80 per cent of Samantha’s property value is $440,000, take away her outstanding debt of $250,000 and she’s left with her possible available equity of $190,000.

While her equity might be $300,000, her available equity is actually $190,000.

How does equity work when buying a second home?

Since equity is the difference between your home’s current value and your outstanding loan value, this amount can be withdrawn as a home equity loan (or second mortgage) and used as the deposit for your second home.

Investors use this as a powerful tool to build their property portfolio, and increasing equity gives them more opportunities for growth.

You increase equity by making regular and consistent loan repayments so that the more you pay off your principal, the more equity you have. Another way equity increases is through capital growth, where the value of your property has increased dramatically from the time you bought it.

Conclusion

Particular requirements must be met before you can accumulate equity on one property and then use it to purchase another location.

When buying a second home in Australia, it’s important to remember that the purchase price may be greater than the market value of the property. This means that while there may be a good chance of increasing equity over time, it will also depend on how much more you’re willing to pay for the property than its market value.

So before you decide to buy another property, take a look at how much equity you have and see if it is worth the investment.