October 20, 2018

How to refinance to buy a second property

If you already own a house, there are plenty of reasons why you might consider buying a second property. Maybe you’re eyeing up a nice holiday home on the coast, or an investment property to rent out. Or maybe you just want to buy a place you’d like to live in down the track, or if not you, your kids. Utilising the equity in your current home can allow you to buy that second property without a cash deposit.

What is equity in a property?

To sum it up in just a few words, your equity in a home is the value of the property minus how much you owe on the mortgage tied to it. To sum it up in more words, we’ll use an example.

Example: Augustine triples the equity in her house over 10 years 

Equity 2nd home

Augustine buys a house for $500,000 with a 20% deposit ($100,000 of her own savings) and a $400,000 home loan. Her equity in the property at this point is $100,000.

Over 10 years, she pays $150,000 off the home loan’s principal (leaving $250,000 owing) and the property’s value increases to $550,000. Augustine’s equity in the house is now $300,000 ($550,000 minus $250,000).

How can you access your property’s equity?

One way of borrowing against the equity in your house is by refinancing your mortgage.

Refinancing is the process of switching home loans, which you might do for any number of reasons besides accessing equity, such as:

  • Saving on your interest repayments
  • Increasing your loan’s flexibility
  • Consolidating debts and lowering fees

To refinance, your lender will typically request a formal valuation to be made on your home. If it has grown in value, your lender may allow you to refinance the home loan based on that property’s new value, allowing you to unlock some of the equity you’ve built up.

Keep in mind that by doing this, you’re essentially borrowing more money, so your principal and interest repayments will be bigger and the loan will take longer to be repaid.

Other ways of accessing your home’s equity

Besides refinancing, there are other options available which can allow you to tap into your home’s equity:

  • Line of credit: A line of credit loan is often more expensive than a traditional home loan, but it can be more flexible. These loans provide access to a set level of credit based on your home’s equity. You can use funds up to this set level and interest is only charged on the amount that you use. These funds are secured against the equity of your home.
  • Reverse mortgage:  Reverse mortgages allow people to borrow against their equity, but don’t require them to make repayments while they still live in the home. Instead, the interest compounds over time, and borrowers only have to repay the balance in full when they either sell the property or pass away. People under a certain age may not qualify for a reverse mortgage, as they tend to be geared towards older Australians who are ‘asset rich but cash poor’.
  • Cross collateralisation: Using the equity in one home as security for loans on one or more other properties is known as cross-collateralisation. Some people consider this to be a high-risk strategy, because if you can’t service the debt on one of the loans, you could lose more than just that one property.
  • Redraw facility: Any extra repayments you make on your home loan beyond the minimum monthly/fortnightly requirement can be accessible through a redraw facility (if your mortgage has one).

How can you refinance a mortgage to access your home equity to buy another property?

To demonstrate this, let’s revisit Augustine’s case again.

If Augustine wanted to access some her $300,000 home equity to use as a deposit on a second property, say, a rainforest retreat-style holiday house, she could consider refinancing her existing mortgage. Just like her first home, she’ll have to pay a certain percentage of that new property’s value upfront as a deposit, which might be around 20%, leaving her with an 80% LVR (loan-to-value ratio).

Now, it’s unlikely that Augustine would be able to use all of her equity. While it can depend on a variety of risk factors (e.g. income, credit rating, property location), lenders generally allow borrowers to access up to 80% of their property’s value, minus their outstanding debt.

So, in Augustine’s case, 80% of her property’s value ($550,000) is $440,000. Take away her outstanding debt of $250,000 and she’s left with her possible available equity of $190,000.

So while Augustine’s equity might be $300,000, her available equity might be $190,000, which she could use towards a deposit on her holiday house.

Value of Augustine’s property $550,000
Augustine’s outstanding mortgage debt $250,000
Value of her property @80% LVR $440,000
Available equity in home $440,000 – $250,000 = $190,000 

Keep in mind, the value of Augustine’s home ultimately comes down to what her lender thinks it’s worth, not the wild numbers thrown around by her speculative neighbour Darren or “it should be worth more than…” guestimate from her local real estate agent. The lender bases this on a valuation report from a certified valuer, which the borrower (Augustine) will most often have to pay for.

How to raise your home’s equity

The more your house has risen in value since you bought it, the more equity you’ll have. So if you’ve owned your house for several years, then your equity may have risen significantly. Over the past 30 years, Australian housing prices have risen an average of 7.2% per year in nominal terms, according to the Reserve Bank of Australia’s Long-run Trends in Housing Price Growth report.

So you might have built up some substantial equity already without even trying.

Other ways of increasing your home equity include:

  • Renovating to boost the value of the home by more than what the renovation costs (e.g. adding another bathroom or building a pool)
  • Making larger mortgage repayments
  • Making more regular repayments – fortnightly or weekly
  • Using a home loan offset account to reduce the interest you pay on the loan

Equity refinancing tips and traps to be aware of

As with any major financial commitment, refinancing to access a property’s equity is definitely not risk-free.

If you’re using the equity to put a deposit on a second house, you’ll essentially be paying off two home loans instead of one, so you’ll need to ensure your cash flow can handle it. Also, as mentioned earlier, refinancing your current home to access equity is essentially increasing the debt on your current home loan, so you’ll be paying it off for longer and thus paying much more in interest over the life of the loan.

You also need to consider the consequences property investment will have on your portfolio. Having most of your money tied up in the property market may leave your wealth overly concentrated in that one asset class, instead of having a diversified portfolio of cash, shares and property. So if the property market experiences a widespread dip, so too could your wealth.

Have a safety net available

If you’re purchasing your second property as an investment property, then be mindful that there may be periods of time where you aren’t receiving rental income, due to not having any tenants or your existing tenants suffering from unexpected circumstances like financial hardship or another tenant passing away or becoming injured.

If you don’t have landlord insurance for this, then having a ‘buffer’ of available cash stockpiled for slow periods can help you stay on top of your interest expenses.

Even if it’s not an investment property, a second home can still have some cost surprises, e.g. unexpected faults or damage.

The Two-cent Saver

As something you can leverage to accelerate your wealth, home equity is one of the most powerful things at your disposal as a homeowner. Buying a second property using the equity in your existing home as a deposit, as opposed to saving up a cash deposit, has two major benefits:

  • You can buy that second property sooner: Saving up a cash deposit for another house can take several years, after which the value of the property you want to buy may have increased significantly. So buying that second property now using your home equity may help you get it at a lower price.
  • You’re not dipping into your cash reserves: Having an emergency stash of cash is vitally important for every household. When you’re buying a second property, that cash safety net can become even more important (as mentioned above).

But with increased leverage comes higher risk, so properly assess your current situation and make a decision as to whether you can afford to service and pay off a second home loan (sometimes referred to as ‘stress-testing’). You should also calculate how much it’ll cost you over the life of both your existing home loan and the loan on the second property. Our home loan calculator can help you do that.

And as we always say, if you’re uncertain about any aspect of a potential financial decision as large as a property purchase, consider speaking to a financial adviser to discover what the best course of action is for you.

About the author  ⁄ William Jolly

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