Posted by admin on Aug 10th, 2008

This is the second article of our educational  finance tips series from our friend at BoringBanker.com that talks about equity and leveraging to increase your wealth.

I previously talked about equity in “use your equity” and looked at using equity to minimise your interest costs. Here, I’ll take that a bit further and talk about leveraging on your equity to hopefully improve your wealth by using that equity to invest.

Just beware however this is not a “how to own a billion dollars property portfolio in 6 months” type of article. I have my own view on that sort of dangerous high gear – high risk strategy that could leave you in a big hole!

What I want to talk about here is accessing your equity to buy an investment asset.

The diagram below graphically demonstrates how equity is used toward the purchase of an investment property. The bank lendable value is the amount the bank is willing to lend you against your property, this could be anything between 80 to 100 of the value, but if you borrow over 80 of the security you provide, lender mortgage insurance will be applicable.

From my experience, the property value will differ between lenders because each lender has their own valuation criteria and valuers. Therefore, the value of your property will most likely differ. Keep in mind that value is an impermanent concept and an asset is only worth what the market is willing to pay for it, therefore what you believe your house is worth is not necessarily what the bank will value it at. You can use your own valuer, but make sure to check if your lender is willing to accept a valuation from the valuer of your choice. Also, be careful when choosing a valuer, a unrespectable one will most likely result in a rejection from lender. Wasting your time and money.

As you can see in the diagram, the difference between the bank lendable value and the current loan balance / limit is the equity that you can extract to invest. In the example above, the equity is used toward your deposit and legal costs in a new property, effectively you will be borrowing the full purchase price of the new property including costs. Obviously, it all depend on how much equity you have and how much you want to borrow against the property, be 80 or 100.

So the basic concept is very straight forward. You use the equity you have as collateral to borrow for a new investment, that’s it. You can use your equity to purchase shares or any other investments that you consider is appropriate and will contribute to your overall wealth in the long term.

However, how do you best structure your loan accounts?

There are a few ways of structuring your loans account to do what we just discussed. In my opinion, the best way to structure this is to keep the properties separate with separate loan accounts as shown in the diagram. The banks like to lump all your properties together into one security pool and then provide you loans against your security pool (known as cross-collateralisation). This is convenient but it does not benefit you, because:

1. You’re forced to go with one lender. In the example above, investment loan #2 can be sought from another lender if it’s more beneficial to do so. Having different lenders is especially important when your portfolio grows because this will spread your risks by not having all your eggs in one basket, as the saying goes.

2. If you experience financial difficulties, the bank can sell any property in the security pool and therefore could kick you out of your family home. Basically, cross-collateralising reduces the bank’s risk which means more risk for you. For instance, if one of your investment loans is in default for some unforeseeable reasons, the bank can sell any of the property in the security pool, which ever easiest to sell to reduce debts. That’s the worst case scenario, however in practice most banks would work with you to sort things out, anyway that’s another topic all together.

In our example, you would end up with three loan accounts, it’s a bit tedious to manage when you expand your portfolio with more properties and more loan accounts, however by doing this you’re quarantining the family home from the bank should things goes wrong. Consequently, if things do go wrong, your family home loan repayments would take priority.

That is how you use your equity to buy an investment property, the process is repeated when you want to buy another and so forth.

Final words of wisdom, it’s all good to have equity to offer as security to borrow and invest, however borrowing to invest has risks, and you need to weight up the risks. Think about what repayment would you have to make, can you afford it? How many more rate rises can you afford? The bank will definitely look at your ability to services the debts, they won’t just give you a loan simply because you got the security, well not the good ones anyway.