You’ve probably often heard of the term ‘Equity’ when it comes to real estate in particular. Some people can find the concept challenging, in this blog I will simplify the meaning of the term Equity and how you can use equity to build wealth.
What is equity?
Simply put, Equity is the money you would have left over if you sold an Asset and paid off all your debt related to that asset so in the real estate example – it would be your ownership of the property minus the home loan. For example, say you have a house worth $500,000 and you have a home loan for $300,000, your Equity would be $200,000 because if you sold the house for $500,000 and paid off $300,000 from the sale then you would have $200,000 left over. The explanation above ignores transactional costs and any tax you may have to pay but this is essentially what equity is, not just in real estate but with any asset you own. Another thing to remember is that when it comes to bank speak, there is a difference between equity and accessible equity, I will explain below.
What is accessible equity?
You may have heard people talk about using the equity in their house to purchase further investments or even other Assets such as cars, boats etc. This is another feature that most Australian banks enable you to access to reduce your overall repayments and saving requirements when it comes to those larger purchases.
Before I go on to how this works, it’s important to understand the difference between ‘equity’ and ‘accessible equity’. While I’ve explained what equity is above, accessible equity is slightly different as it helps manage the banks risk. As a rule of thumb, your accessible equity is usually 80% of your property value minus your loan amount. Let’s use the same example as before to bring this to life. Your property is worth $500,000, your loan is for $300,000 and your equity is $200,000. To work out your accessible equity, you would take 80% of your property value and since 80% of $500,000 is $400,000, you would use $400,000 in this case. You would then subtract $300,000 which is your loan and come up with an accessible equity figure of $100,000.
How do I use equity to buy things?
The way this works is that the bank is usually pretty comfortable lending up to 80% of a property value regardless of how you use the money as long as the money is secured with the property. So in the worst case, if you couldn’t pay your loan, the bank would still have your property to fall back on.
If your loan is less than 80% of your property value, you would have accessible equity so the bank would be willing to lend you the amount of the accessible equity without needing to provide further security (other than your house) provided you can service the debt. Servicing the debt basically means that you earn enough money to show you can pay off the loan.
Using the same example as before, let’s suppose you wanted to buy a car worth $50,000 and didn’t want to get a car loan since the interest rate is a lot higher. You could apply for a loan increase in your home loan to access your accessible equity to buy the car and since your accessible equity is $100,000 and you only need $50,000 for the car, the bank would be willing to lend you the money provided you could service the debt. This would generally mean you pay a lower interest rate than a car loan.
Can I increase my accessible equity?
Yes you can – the 80% rule is generally true however you can access more than 80% but need to help the bank manage their risk. In all likelihood, you would need to take out lenders mortgage insurance (LMI) if you wanted to access more than 80% of the properties value – see my blog on house deposits for further information – the same principles apply
How do property investors use equity? (cross collateralisation)
I thought it would be important to mention that although you can buy assets like cars, boats etc. using equity, it is not the best use for it if you want to grow your wealth in the longer term. Successful property investors use equity to buy further properties without having to save as much for a deposit.
The way they do this is by using growth in property values and reducing their loan amounts to fund their next property purchase. In the earlier example, if you have accessible equity of $100,000 – you could buy a $500,000 property without needing any additional savings !
Let’s play this through – suppose Bob wants to be a property investor and saves $80,000 to buy a house. He then goes on to buy a house for $400,000 and takes out a loan for $320,000. Over the next year, Bob makes his repayments and his loan reduced to $300,000 but he learns that the value of his property has increased to $500,000. He has also just seen another $500,000 property he wants to buy and so approaches the bank. The bank lends him the full $500,000 to buy the house because he has enough equity to cover the 20% deposit. This is because both of Bob’s houses combined are now worth $1,000,000 and his loans combined are worth $800,000 so still at 80% meaning Bob doesn’t need a deposit. By doing this, Bob is offering both properties as security for both loans. In bank speak, this is known as cross collateralisation.
Bob would still need to show that he makes enough money to service the debt but Bob can use the rental income from the properties he purchased to help improve his servicing position.
In a nutshell, equity is the portion of an asset that you own after accounting for any loans. Accessible equity is the additional money the bank would be willing to lend you without asking for another property or asset as security.