How Does Equity Work When Buying a Second Home?
Purchasing investment property based on equity
Kiwis love to invest in properties and using equity in your existing properties portfolio to buy another property for investment is very popular.
Now what is equity? How do you calculate your equity?
Many people get caught out on this. Equity in your existing properties is not the difference between how much your property is worth and how much you owe to the bank. It actually is how much the bank will lend to you against your property depending upon the use of the property (whether owner-occupied or rental) and how much you owe to the lender against that property. As an example, if your property value is $1 million and you currently owe the bank $500,000, then the equity calculation will be as follows:
1- if it is owner-occupied property, the bank may lend you up to 80% against this property and you already owe the bank 500,000 which means you have an equity of $300,000.
2- if the existing property is a rental property, as per current regulations the bank may lend you up to 65% of the value of the property which comes to $650,000 and you have equity off $150,000 on this basis.
Please note the above calculation is just to clarify the concept of equity and availability of equity is not the only assessment criteria for the banks, which requires further assessment including serviceability analysis.
As per current rules, the deposit or equity requirement for rental properties is 35% if it is an old existing property and it can be even 10% deposit if it is a “newly built property”. It may differ with different lenders slightly but broadly speaking, the definition of “newly built property” is that you purchase it direct from the developer and the Council Code of Compliance should not be any more than 3-6 months old.
Now that you know how to calculate equity in home? Let us have a look at how to use it in an actual purchase transaction. As an example, if you have equity of say $210,000 in your existing property and you want to buy an existing house as your rental property, which requires a 35% deposit or equity:
1- If you are purchasing the rental property for up to $600,000, the maximum deposit you require is $210,000 at 35% of the purchase price. Since you already have equity available in your existing property up to $210k, you do not require to contribute any cash deposit and the bank may lend you the full purchase price of $600,000 in this case (subject to other lending criteria). Needless to say here that you are free to make cash deposits if available, which will reduce your lending amount and also the interest cost.
2- If however, you are purchasing the rental property for more than $600,000, let’s say $800,000, then you require a total deposit of $280k, out of which you can use your available equity of $210k but will require to contribute another minimum $70k as a cash deposit.
Please note that it is common practice with banks to what they call “cross-collateralize” your properties mortgaged to them. This effectively means that the whole debt that you took for two or more properties will be secured by all the properties which you offered to the bank as security. If and when you sell one property out of properties, the bank may insist upon you having to deposit the full net sale proceeds towards permanent debt reduction. In many cases, upon subjective assessment, the bank may allow you to retain some funds, subject to the bank’s approval.
You may sometimes want to Refinance your rental property to another bank to achieve your objectives. In some cases, where you find that there has been equity erosion in your rental property due to adverse market conditions and the available equity is not meeting the minimum thresholds as mentioned above, please talk to your Mortgage Advisor as there could potentially be some options available such as “dollar to dollar refinance”, noting that it is very subjective on a case-by-case basis and requires assessment by a professional mortgage adviser and/or banker.
Other important things to remember when you are using your equity for buying investment property:
1- Legislation around the taxation of your rental income as there may be certain exemptions or deductions available – we encourage you to speak to your Accountant for a detailed discussion on this.
2- We encourage you to have a detailed discussion around the structure of your property’s portfolio with your Accountant, who may among other things suggest to you a different ownership structure, such as trusts or look through company etc.
3- Legislation around your obligations on the property health & safety standards and also your other obligations towards the tenants.
4- There may be additional costs such as legal cost at the time of purchase, registered valuation costs, etc.
5- The house insurance may be different from your owner-occupied house insurance as it may have additional cover available for damage to property or loss of rent etc. Please have detailed discussion around all additional aspects on rental property insurance with your insurer.
Purchasing an Investment Property using your existing equity can be a complex transaction, which requires an in-depth analysis of your objectives, available equity, income & cash flow before and after purchase, explore options to maximize your tax efficiencies among many other things.
We strongly recommend you take advice from your lawyer, accountant and your Auckland Mortgage Broker. Call us at 0508 33 22 11 (Toll-Free) 021 030 8135 or email at (info@kiwimortgages.net.nz) to
get support from one of our experienced advisors – free of charge.