Equity and borrowing

[SupaRex]

Hi Everyone,

I'm sorry, but this is doing my head in. Really I should know this.

If I had an IP that I bought for $200k and one year later it is worth $400k that would mean I have $200k equity in it, right?

Now, as I (partially) understand it, that means I can use (80% of $200k) $160k.

Does that mean then, that if I found a house for $160k, I could buy it using just the equity I had and not actually borrow anything?

That can't be right!

 

[The Y-man]

Yes you can, but you will now have a $360k loan against IP#1.

Cheers,

The Y-man

 

[Chris.R_WA]

Close, but you can actually only access 80% of the new value (400K), assuming this is the most you want to borrow (could prob go higher with LMI).

So 400K x 0.8 = 320K

320K - 200K (that you already owe) = 120K available equity for use


Regards, Chris

 

[SupaRex]

Thanks Y-Man, but why would I have $360k against IP#1? Why would I borrow the $160k against IP#1 when I already "have" the $160k as equity?

I know I'm wrong here , I just don't understand why, so please work with me here!

 

[The Y-man]

Close, but you can actually only access 80% of the new value (400K), assuming this is the most you want to borrow (could prob go higher with LMI).

So 400K x 0.8 = 320K

320K - 200K (that you already owe) = 120K available equity for use


Regards, Chris

Ooops! You're right of course

Cheers,

The Y-man

 

[mrsdawnrazor]

because you have to pay the seller $160k for the new property which you get from withdrawing the equity from the first house

 

[The Y-man]

Thanks Y-Man, but why would I have $360k against IP#1? Why would I borrow the $160k against IP#1 when I already "have" the $160k as equity?

I know I'm wrong here , I just don't understand why, so please work with me here!

"Accessing Equity" works by "drawing down" the equity - think of it as taking out a second loan against the same property.


Cheers,

The Y-man

 

[stumunro]

equity can only be accessed by borrowing money against it.

basically the bank looks at your property and says.. hey its worth 400k, what we can do is give you cash, to the value of your equity. but the cost of us giving you this cash is interest!

normally the only way you could get access to the equity, is to sell the property. This way you can keep your original assett, but access the funds for a fee (interest)

 

[mikew]

"accessing equity" is newspeak for "borrowing more"

 

[SupaRex]

because you have to pay the seller $160k for the new property which you get from withdrawing the equity from the first house

Aaaah! Now that makes sense, since you can't give the seller 'equity', they would want cash!

 

[SupaRex]

equity can only be accessed by borrowing money against it.

basically the bank looks at your property and says.. hey its worth 400k, what we can do is give you cash, to the value of your equity. but the cost of us giving you this cash is interest!

normally the only way you could get access to the equity, is to sell the property. This way you can keep your original assett, but access the funds for a fee (interest)

Hmm. So, even if I (magically) had enough equity in one IP cover the cost of another IP, I'd still have to borrow the full amount. The equity gives me (the bank) the security to borrow the money I need.

Mmm. So in my case, DSR will become an issue in the future. The part that was messing with my head was I was thinking I only had to borrow the difference between the equity I had and the mount I needed to purchase the IP. Further, I was thinking, if that's the case, then if I had enough equity, I wouldn't need to borrow anything!

Anyway, I hope some of that made sense. Thanks to all of you for helping me clear that up.

Cheers,
SupaRex

 

[scamp]

Yes, now look at it from the other ( less magical ) side :

Equity is the difference between the market value of the property and the liability you have in the property. If someone values your house at 400.000, and you have a liability of 200.000 in the house, that means you have an equity of 200.000. The amount of money you borrow from the bank isn't the actual equity, it's just a loan, a mortgage, which is backed by the current value of the house. Mortgages are always backed by something. In the case you can't pay off the interest, the bank will sell your house for as close to market value as they can ( usually about 80% ), take whatever loan you have on the bank and give you what's left of the selling price.

Now imagine what happens in the current climate :
Someone values your house at 400.000. You take up 150.000 extra mortgage, making your total liability 350.000 in your house 'worth' 400.000. Suddenly you can't pay your mortgage anymore, let's say oil prices doubled, food prices doubled, and interest rates go up about 3% ( a highly unlikely scenario, but let's assume it could happen ). That means you can't pay your mortgage anymore.

Your bank will send you an eviction notice and try and sell your house. Since everyone is in the same boat , unable to pay their loans, there's very few people interested in buying your property. This means the bank eventually sells your house for 200.000 , the price that YOU paid for it in the first place, and actually the REAL value of the house ( real value because noone will pay more for it ).

Now you have 150.000 mortgage left which are uncovered. You *need* to pay these 150.000 or you have to mortgage your other house. The bank values that house at 50% of the price just like your other house ( that's 75.000 ), which leaves you with 75.000 debt , PLUS all the interest you paid over the years on your 350.000 loan ( let's say another 75.000 ).

Conclusion :
You paid 225.000 for a house worth 75.000
And that is the less 'magical' side of real estate.

 

[BayView]

That's a more common result than people know.

But it is all avoidable, no matter how much doom and gloom there is in the air. If the investor knows the risks and invests with the worst case scenario in mind.

For example; if you have $150k of USEABLE equity to spend on another property, use only $100k or so to leave a buffer of funds to fall back on when life smacks you in the gob.

Another one is to make sure there is a sensible yield of rent when you are crunching the numbers. Too many stories surface of investors jumping on the band-wagon and accepting ridiculous yields such as 2 and 3% because someone told them it was the place to invest (Sydney springs to mind of recent years).

Make sure there is a good depreciation amount to help soften the cashflow blow, and so on.

 

[grossreal]

hi L.AAussie
interesting post except most of sydney is doing alot beter the 2 or 3%.
at 13k 3% is 433k
some are doing 13k for 210k so your numbers are out a bit.
comm is running at 8 to 9% net yeilds so again thats not the 3%
not one to generalise but if some one is running on a 3% not sure where they are buying and if the own they were well over to start with.
2 and 3% is in the gold coast not sydney as they are running on equity not return.
this is just to balance up the book.
equity is
the value 1mil
less the lvr for the property class so say 80%
800k
less the loan say 600k
200 equity.
and this then can be used
and it would take about 3 pages on how to use it

 

[The Y-man]

But it is all avoidable, no matter how much doom and gloom there is in the air. If the investor knows the risks and invests with the worst case scenario in mind.

Agree. Maybe not 100% avoidable, but some good risk management is mandatory, eg
Landlord Insurance
Income Insurance
Building Insurance

and

making sure your repayments are well within your capabilties - even if the bank will lend you more!

Cheers,

The Y-man

 

[duckster]

securing the new loan

You can use the first property as security for the second loan this is know as cross colaterialisation. The risk is that if you get in trouble you can lose both houses. So bank adds up both property values and both loans and works out if LVR is acceptable. You borrow more for the second property this way and risk losing both properties if something goes wrong with you paying off the loan.

 

[murtagh]

You can use the first property as security for the second loan this is know as cross colaterialisation. The risk is that if you get in trouble you can lose both houses. So bank adds up both property values and both loans and works out if LVR is acceptable. You borrow more for the second property this way and risk losing both properties if something goes wrong with you paying off the loan.

Yes, or you draw down some equity on your first property. And wind up with cash you can access to invest with (whether this is a LOC or an Offset account, or some other "place that holds money that you can access" is an implementation detail).

Then you go buy property #2 using the available (already borrowed) cash as deposit/costs.

Bingo, you've just done the same thing but without cross collateralizing your properties/loans.

 

[BayView]

hi L.AAussie
interesting post except most of sydney is doing alot beter the 2 or 3%.
at 13k 3% is 433k
some are doing 13k for 210k so your numbers are out a bit.
comm is running at 8 to 9% net yeilds so again thats not the 3%
not one to generalise but if some one is running on a 3% not sure where they are buying and if the own they were well over to start with.
2 and 3% is in the gold coast not sydney as they are running on equity not return.
this is just to balance up the book.
equity is
the value 1mil
less the lvr for the property class so say 80%
800k
less the loan say 600k
200 equity.
and this then can be used
and it would take about 3 pages on how to use it

Quite right Lawrence, and I also agree Y-Man.

Mine was a generalisation, but there were reports of these sorts of buyings a year or so ago.

On that note G.R, what is your criteria for minimum yield before you are interested in buying?