A key aspect of investing is working out your long-term financial strategy. You need to know the amount you need upfront and what you’ll need after the purchase.
This is a crucial step that needs to be done early and in detail, being as conservative as possible to prepare for worst-case scenarios. Careful planning will help you avoid financial and emotional stress down the track.
There are a few areas to consider. The 3 aspects we’ll look at today are:
- Cash vs equity: what is equity and is cash or equity better to use?
- Serviceability: can you comfortably keep up repayments on your loan?
- Deposit amount: how much should you expect to pay for a deposit?
Cash vs equity
Firstly, what is equity?
It’s the difference between the value of your property and how much you owe on your home loan. For instance, if Jack and Mary’s home is worth $500,000 and they’ve got $300,000 debt on their home loan – they’ve got $200,000 of equity in their home.
Jack and Mary’s home: $500,000
Amount owing on home loan: $300,000
A common way to buy investment property is to use the equity in a current home. It means you may not have to come up with any cash at all – or very little for a deposit. That cash can instead be kept in reserve for renovations or other expenses.
The maximum home equity you can use for a deposit is typically 80% of your home’s value less the balance of your home loan.
Max equity for Jack and Mary’s home: $100,000: $400,000 (home value) – 300,000 (amount owing)
So Jack and Mary may have $100,000 of equity for their deposit and other buying costs such as stamp duty and settlement fees. If they need more, they’ll need cash.
Note: It’s not a given that you can use the maximum equity in your home. The bank will look at your age, other debts, your income, and other factors.
Should you use cash or equity to buy your property?
Paying in cash means:
- You’re mortgage-free (and free from mortgage stress!)
- It may be appealing to the seller and speeds up the buying process
- You’re protected from the effect of market downturns on a loan
- Fast tracks the number of properties you can buy and supercharges your returns
- Leverage can be risky without a solid investment strategy and carefully chosen properties
- Gives you more cashflow in reserve
- Offers a good interest rate
- You can avoid paying Lender’s Mortage Insurance (LMI): needed to cover the lender’s risk of you not paying your loan when you have less than 20% deposit.
Generally, equity is the most common way to buy an investment property as not much cash needs to be used. However, every circumstance is different. It’s best to check in with a finance professional who will help you work out what’s best depending on your financial situation and investment strategy.
Key takeaway: There are pros and cons to using cash or equity. Equity will likely be suitable most of the time and can fast track your investment efforts. Get professional guidance.
Many investors will borrow to invest. Serviceability is your borrowing power – how much banks will lend you to buy an investment property.
This affects what you can afford to buy.
Experienced investors take serviceability one step further: they look at future serviceability. What can you afford to borrow after you buy this property?
Considering future serviceability is important if you want to grow your portfolio.
How is serviceability calculated?
In general, lenders use the same formula:
less existing commitments
less new commitments
less living expenses
= your monthly surplus (i.e. the amount left to repay your mortgage).
The factors included in the calculation might be slightly different across lenders. They generally ask for your monthly expenses, annual income, type of loan, repayment structure, current interest rate, and estimated monthly repayments.
5 Ways to improve your serviceability
- Cancel unneeded credit cards and reduce card limits
- Extend your loan term
- Save hard
- Get a mortgage broker to help you find the right loan
- Prove you have a stable income now – and in future
Key takeaway: Serviceability is your borrowing power and it’s helpful to consider how much you can borrow now – and in the future.
In general, the deposit on a property could be 10% or less of the property’s value. However, to avoid lender’s mortgage insurance (LMI), many buyers fork out a 20% deposit.
The bigger your deposit, the less you have to borrow. But since interest paid on an investment loan can normally be claimed as a tax deduction, investors have less incentive than homeowners to put up a large deposit.
Key takeaway: A deposit reduces the amount you borrow. Check your financial situation and investment strategy to work out what deposit amount will be best for you.
Careful planning done early is key to a successful investment. Today we’ve looked at ways to fund a property, cash or equity. We’ve explored why your purchase depends on your borrowing power or serviceability. Finally, you’ve seen that a typical deposit is 20% though there are times when it might suit to pay less.
If you’ve been umming and ahhing about investing, planning can help you understand whether to go ahead or not.
Contact us for your free, no-obligation, 30-minute consultation.