Using Equity - How it actually works?

[jmillar]

Hi All,

I?ve done some researching into the use of equity but I can?t seem to find anything which gives a good break down of how it actually works.. Can you tell me if I?ve got the below calcs right?

Say you have $1M PPOR no mortgage, so $1m equity and you can access say 80% so $800k.

You purchase a $800k investment property (incl purchase costs etc etc).

So you now have a $1M PPOR with $800k debt, and a $800k IP with no debt ? is this correct?

Do you have any repayments on either property? How is this calculated?

John

 

[Terry_w]

Hi All,

I?ve done some researching into the use of equity but I can?t seem to find anything which gives a good break down of how it actually works.. Can you tell me if I?ve got the below calcs right?

Say you have $1M PPOR no mortgage, so $1m equity and you can access say 80% so $800k.

You purchase a $800k investment property (incl purchase costs etc etc).

So you now have a $1M PPOR with $800k debt, and a $800k IP with no debt ? is this correct?

Do you have any repayments on either property? How is this calculated?

John

You have borrowed $800,000 to buy a property so will have $800,000 in debt and loan repayments on this.

 

[alexlee]

You still haven't described what equity is, John.

Equity is the value of an asset less what you owe on it.

You can access equity by borrowing using it as security.

This is good because you can access (usually) the increased value of the asset without having to sell it. However, you can rarely access all of the equity (since you're limited by what the bank will lend on it). If the bank isn't willing to lend at all (rules change all the time), you can only use the equity if you sell the asset.

In practice, it's about using increased asset values for further investing, instead of saving from salary, etc.

 

[see_change]

In the situation you have described , what we did was ( not precise figures )
1 mill property , Get 800 K Line of credit ( LOC )
Purchase next property eg IP worth 400 K

Money for that can came from two places.

1 . Loan on the new IP eg 90 % LVR , so borrow 360 K secured against the IP and then draw down Equity from LOC to make up the difference which would be 40 K plus legals and stamp duty eg 20 K

So you have only drawn down 60 K from you 800 K LOC on your PPOR .That means you still have 740 K left in your PPOR.

Obviously this raises the prospect of buying several IP's using equity from you PPOR.

Obviously this can increase you returns , but also significantly increases your risk.

If you get that balance wrong you can go BANKRUPT ....

however if you get it right , you can make a lot of money .

There are people on this forum who have done both and many who have lost money without going BANKRUPT .

Cliff

 

[jmillar]

You have borrowed $800,000 to buy a property so will have $800,000 in debt and loan repayments on this.

Thanks Terry.

In the situation you have described , what we did was ( not precise figures )
1 mill property , Get 800 K Line of credit ( LOC )
Purchase next property eg IP worth 400 K

Money for that can came from two places.

1 . Loan on the new IP eg 90 % LVR , so borrow 360 K secured against the IP and then draw down Equity from LOC to make up the difference which would be 40 K plus legals and stamp duty eg 20 K

So you have only drawn down 60 K from you 800 K LOC on your PPOR .That means you still have 740 K left in your PPOR.

Obviously this raises the prospect of buying several IP's using equity from you PPOR.

Obviously this can increase you returns , but also significantly increases your risk.

If you get that balance wrong you can go BANKRUPT ....

however if you get it right , you can make a lot of money .

There are people on this forum who have done both and many who have lost money without going BANKRUPT .

Cliff

Thanks Cliff. For some reason I couldn't get my head around this concept last night..

So basically if you fund a property with equity, you're reducing your equity in the original property and turning it into debt.. Which effectively makes the LVR of the new property 100% if only financed by equity, or part equity and the rest through a mortgage on that new property.. Correct?

So with the situation of buying a $400k IP:
a) You use $200k equity from your PPOR and have the remaining $200k debt against the new IP
OR
b) You use the whole $400k equity from your PPOR

Regardless of whether you choose option a) or b), you are still paying your repayments based on the $400k as it is all debt.. the only difference is it is secured against 2 properties in situation a, and 1 property in situation b.. Is this correct?

Cheers

 

[see_change]

Thanks Terry.



Thanks Cliff. For some reason I couldn't get my head around this concept last night..

So basically if you fund a property with equity, you're reducing your equity in the original property and turning it into debt.. Which effectively makes the LVR of the new property 100% if only financed by equity, or part equity and the rest through a mortgage on that new property.. Correct?

This is correct

So with the situation of buying a $400k IP:
a) You use $200k equity from your PPOR and have the remaining $200k debt against the new IP
OR
b) You use the whole $400k equity from your PPOR

Regardless of whether you choose option a) or b), you are still paying your repayments based on the $400k as it is all debt..

This is correct .

the only difference is it is secured against 2 properties in situation a, and 1 property in situation b.. Is this correct?

Cheers

Yes and no . The LOC is against your PPOR , so at no stage do you have a mortgage on you IP secured against you PPOR .


The reason to minimise the draw down from the LOC is two fold . It means you have more funds available to buy further properties and second , you have more funds available as a buffer if you have a problem .

In the last Cycle we bought 19 IP's using this approach . Admittedly they were only costing us around 65 - 80 K each IP and I do have a good income , but we never got close to drawing down all the LOC . If I'd lost my job and we had no income from any of the IP's we had well over a years buffer .

We sold down most of those IP's ( only have four of those left now ) to pay down debt and to fund a development . We started the process again just after the GFC struck and have bought several , more upmarket properties , the last ones being in Brisbane in late last year.

At this stage we're standing on the sidelines watching our equity go up.

Cliff

 

[Aaron_C]

Equity is converted into debt by property investors so they access that equity in the form of cash. Your net equity position remains the same because you are increasing debt by say $800k, but you also get cash of another $800k.

 

[jmillar]

Yes and no . The LOC is against your PPOR , so at no stage do you have a mortgage on you IP secured against you PPOR .

The reason to minimise the draw down from the LOC is two fold . It means you have more funds available to buy further properties and second , you have more funds available as a buffer if you have a problem .

In the last Cycle we bought 19 IP's using this approach . Admittedly they were only costing us around 65 - 80 K each IP and I do have a good income , but we never got close to drawing down all the LOC . If I'd lost my job and we had no income from any of the IP's we had well over a years buffer .

We sold down most of those IP's ( only have four of those left now ) to pay down debt and to fund a development . We started the process again just after the GFC struck and have bought several , more upmarket properties , the last ones being in Brisbane in late last year.

At this stage we're standing on the sidelines watching our equity go up.

Cliff

Thanks for the clear explanation Cliff, I understand. Much appreciated.

Equity is converted into debt by property investors so they access that equity in the form of cash. Your net equity position remains the same because you are increasing debt by say $800k, but you also get cash of another $800k.

Thanks Aaron, that helped also. So in Situation A you lose $200k equity in the PPOR but your new IP now has that $200k debt, and $200k equity.

Cheers guys.

 

[alexlee]

The most important part is not which property has what equity and what %. The important thing to note is that you didn't have to save from salary, etc to buy the IP. You used the increased value in the first property as a deposit for the second.

However, also note that you needed a bank to lend you money based on the increased value. There are variables like the bank's valuation, and how they assess your serviceability (which is based on salary, other income, etc).

 

[Aries]

However, also note that you needed a bank to lend you money based on the increased value. There are variables like the bank's valuation, and how they assess your serviceability (which is based on salary, other income, etc).

I hope it is OK to ask a further question here.

If the person in John's scenario fully owned $1M house (ideally can access 80% = 800K) but is earning $50pa, can this person still access the whole 800K if we consider the serviceability?

What is a more realistic figure for this person to access, if he/she has to meet the serviceability criteria?

 

[Peter_Tersteeg]

It is realistic to borrow up to $800k on a $1M property (assuming serviceability is evident). If you're trying to access $800k of the equity it can be a bit tricky as many lenders aren't keep to simply hand over $800k in cash, but it can be done under the right circumstances with the right lender. There isn't a simple answer to this, you need to get professional and specific advice.

Getting $50k rental income from the property contributes to serviceability, but this isn't sufficient information to give a qualified answer as determining serviceability is more complex than simply having enough rent to cover the loan payments.

 

[Aries]

Thank you PT Bear!

I didn't think of the rental income.
I was just thinking based on John's scenario, but wondering what will happen if the person is asset rich (ie. 1M PPOR) but cash flow poor (say, the $50K income is his/her annual salary).
I guess it is an unlikely situation

 

[alexlee]

I was just thinking based on John's scenario, but wondering what will happen if the person is asset rich (ie. 1M PPOR) but cash flow poor (say, the $50K income is his/her annual salary).
I guess it is an unlikely situation

Not at all. You've just described a lot of lower income, older people or retirees who have few assets other than their own homes.

 

[Aries]

Thanks, Alex

What if the person's only asset is the PPOR?
Does serviceability become an issue in this case?

In a retiree's case, what if there is no income coming in except super/pension?
Can John's scenario still work in this case?

PS.
Sorry if the questions sound silly, I am trying to get my head around this.

 

[alexlee]

What if the person's only asset is the PPOR?
Does serviceability become an issue in this case?

In a retiree's case, what if there is no income coming in except super/pension?
Can John's scenario still work in this case?

I'll let the mortgage brokers confirm, but I'd say it's unlikely.

The point being, you try not to let it get to that point in the first place. You invest early, learning as you go. If that means delaying 'paying off' the PPOR debt for a few years, as long as the investments perform that's not really an issue.

Also, some will advise you to borrow when you can even if you don't need it, because you never know when circumstances change and you won't be able to borrow. e.g. you might qualify for a line of credit against the PPOR when you're employed, but as soon as you lose your job, no bank will touch you.

 

[Aries]

Thanks again, Alex.

I am learning more everyday

 

[CHAOS]

Can someone advise what happens when you sell PPOR?

eg your 800k equity has been used as 5 200k IP deposits.

When you sell your home and the PPOR loan is paid out - does this essentially pay out each of the 200k deposits and hence you lose the tax deductibility of that potion of the IP loans?

Say you were selling od PPOR to purchase a new PPOR but old PPOR equity is supporting IPs - not sure if I have explained that clearly.

 

[alexlee]

Can someone advise what happens when you sell PPOR?

eg your 800k equity has been used as 5 200k IP deposits.

When you sell your home and the PPOR loan is paid out - does this essentially pay out each of the 200k deposits and hence you lose the tax deductibility of that potion of the IP loans?

Yes, because those 5 x 200k loans are secured against your PPOR, and if you sell the PPOR you have to repay everything. What you used the proceeds for doesn't matter in terms of repayment.

Say you were selling od PPOR to purchase a new PPOR but old PPOR equity is supporting IPs - not sure if I have explained that clearly.

Doesn't matter what you do next. When selling a property, any loans using that property as security must be repaid.

 

[CHAOS]

So this would be one of the negatives of using equity in your PPOR to increase your portfolio?

 

[alexlee]

So this would be one of the negatives of using equity in your PPOR to increase your portfolio?

Why? If NOT using the PPOR equity to increase your portfolio means you're unable to increase the portfolio, it's not really a negative.

If you have IP equity to use and prefer to leave your PPOR with no loan against it, that's fine, of course.

For a lot of investors who start relatively late, the PPOR is often the only thing of any value they have to use for deposits.