Are you thinking of getting an investment property, or just want to know how equity works when buying a second home? In simple terms, equity is the part of your existing home that you actually own and not just what you’re borrowing. So it’s market value minus what you owe.
For example, if your home is worth $800,000 and you owe $450,000 on the mortgage, your equity is $350,000. You can use that equity as part of the deposit on your next property. This means tapping the value already built up in your current home to fund the new purchase.
Again, that could be for a buy-to-let type property investment or just a house you plan to use as a holiday home, since the mechanics are fairly similar either way. We’re going to break down all you need to know about how this works throughout this article.
Calculating Your Usable Equity
So not all of that equity we mentioned earlier is actually immediately borrowable because lenders usually lend up to about 80% of your home’s value. This means your usable equity is the result of 0.8 x your home’s value – loan balance.
To use another example, on a $500,000 home with $320,000 owed, 80% of $500k is $400,000, minus $320,000 leaves you with $80,000 usable equity. Lenders like CommBank explain this sort of equation when you’re trying to tap into your equity: a $750,000 home with $400,000 owed has $350,000 equity, but only $200,000 usable (80% of value minus loan).
This all essentially means that any deposit beyond your equity must come from you. Lenders generally expect about a 20% deposit (often called a “20 deposit”). If your equity only covers, say, 15% of the price, the remaining 5% has to be a cash deposit or savings.
Keep in mind you’ll still need a bit of extra cash for stamp duty and any fees on the second home. If your usable equity isn’t enough for the full deposit and fees, you must make a cash contribution.
Using Equity to Fund the Second Home
In practice, you’ll be turning that equity into cash either by refinancing or getting a second mortgage. This is also generally one of the more popular ways to buy a second property. A common approach is a home loan top-up: you ask the lender to increase your existing mortgage and withdraw the extra as cash for the deposit.
Alternatively, you might open a separate investment loan against your current home to get the funds. In any case, you’ve effectively borrowed against your own equity.
After the top-up, your mortgage on the original home has increased – you now owe more. For example, if you buy a $400,000 house using an $80,000 equity deposit, the new loan amount is $320,000, and you pay interest on than $320k just as on a normal mortgage. In other words, you’re still paying the lender interest on that money.
Effectively, this means you’re taking advantage of the equity in your home to make this purchase comfortably.
Remember, your first home now secures the second loan too. We appreciate that this might all sound a bit complicated, but the main takeaway here is that using equity ties the two properties together financially.
Pros and Cons
So, what are the main arguments for using this method?
Pros
Using equity to buy a second home can be a good idea if you want to move fast. You’re not going to have to save years for a deposit, and a larger deposit can reduce or avoid lenders mortgage insurance (LMI). This can save you thousands in LMI premiums.
Cons
On the downside, you are increasing your total debt. Your repayments are going to get way bigger and make your cash flow a lot less manageable. You’re basically borrowing more money and increasing the amount you owe when you top up, so your bills go up.
Borrowing an extra $80,000 means paying interest on that $80,000 more debt. Also, keep in mind that investment home loans often carry slightly higher interest rates (0.2 – 0.4% more) than owner-occupier loans.
Some investors even take a short interest-only period on the new loan to improve cash flow, but this means you won’t be building up equity as quickly. Every dollar you borrow via equity is one more dollar of debt you repay at interest.
Investment Property vs Personal Use
If the second home is rented out, the rental income you’re getting from that can definitely help cover the loan. In fact, rental income can give you a steady cashflow, and most of the mortgage interest and other costs on that loan are tax-deductible. You’d also be able to negative-gear any rental loss against their other income.
On the other hand, if you’re just wanting it as a holiday home for personal use then you’re getting no rental income or tax deductions: you cover all interest and costs yourself. Also, any profit on sale will be fully taxable (since it was never your main residence), so you won’t get the main home CGT break.
Borrowing Power and Advice
Before you make a decision, check your borrowing power – the amount the bank will lend you based on your:
- Income
- Expenses
- Existing debts
Even with your equity, lenders need to make sure you can actually service two loans. It’s smart to talk to a lending specialist or mortgage broker. Any proper home lending specialist can explain how your equity and borrowing power work together.
Our service at Upscore also helps you compare home loans and lets you choose the best lender for your needs. And another thing to remember is that interest rates on the new loan will reflect current market levels.
Just keep in mind that it’s not at all uncommon for lenders to charge a bit more on investment loans, and they tend to have different rules for interest-only or fixed terms. If you need some help sorting these details, a broker or even an online tool can calculate your borrowing power (which, again, you can do with Upscore) and match you to suitable home loans.
Grants and Final Thoughts
Unlike first-home buyers, there’s no general grant for second-home purchases in Australia. The First Home Owner Grant is only for first-timers, and most state incentives are only for specific cases.
So basically, there is no national “Second Home Buyers Grant.” (For example, Queensland’s new co-ownership plan was nicknamed the Second Home Buyers Grant, but it’s really just a shared-equity scheme, not a cash handout.)
In summary, using equity to buy a second home means converting the equity in your existing home into the deposit on another property. If you’re in doubt about how any of this works, get professional advice from a broker or financial adviser.
How Upscore Can Help
Ready to explore your options? Try signing up for Upscore’s Finance Passport. It will calculate your borrowing power based on your income and debts, then show you home loan options from different lenders that match your situation.
