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The Sunday Age

Accessing equity to buy an investment property

Jack and Sarah are in their late 30s. They've owned their home for eight years and its worth around $500,000.

Now approaching their peak earning years, but with plenty of time to go before retirement, they want to get a start in the investment market. The trouble is, they don't have the cash to use as a deposit for an investment property. What can they do?

In generations past, people in Jack and Sarah's situation waited until they paid off all their debt on their home, before deciding to buy an investment property. Now, with the advent of more flexible lending products, Jack and Sarah don't have to wait that long. Instead, they can borrow some of the equity in their home and use it to put towards the purchase.

'Equity' is the difference between the amount Jack and Sarah own and the amount they owe. Over the years, they have built up equity as the value of their property has increased in line with wider market movements. They have further increased this equity by making loan repayments over and above the minimum required amount.

As a result, Jack and Sarah now have $200,000 worth of equity in their home and can borrow some of this equity to help purchase an investment property.

This is a two-stage process. First, Jack and Sarah need to set up a line of credit with their lender enabling them to access enough equity to pay for the deposit on the investment property. It's important to note that they don't pay interest on the line of credit until they actually access the funds.

In this sense, a line of credit operates a bit like a credit card. For example, if you have a $5000 limit on your credit card, you'll only pay interest if and when you use it. The big difference is that the line of credit is secured against Jack and Sarah's home, so the interest rate is lower.

At the same time that Jack and Sarah are arranging a line of credit, they need to get an approval-in-principle from their lender, enabling them to borrow up to a certain level. The amount they can borrow will be based on their income, debt level and financial history.

Knowing how much they can spend, they find the right investment property and buy it.

Now, it's time for Stage Two. They need to get final approval from the lender for the investment property loan.

Rather than borrowing the difference between the deposit and the purchase price, they should borrow the whole amount. They can then put the deposit amount back into the line of credit and reduce the balance to zero. This will save them interest because a line of credit usually has a higher interest rate than a loan. It will also simplify their financial affairs at tax time.

Now that they have an investment property as well as their family home, Jack and Sarah can really start to accelerate their equity accumulation. This will put them in a sound financial position in later years when they come closer to retirement.

In the meantime, they have two different kinds of debt. The debt on their investment property is tax deductible; that is, they can claim holding costs like interest, municipal rates and maintenance against the rental income. The debt on their family home, by contrast, is non-tax deductible, so it's more expensive to repay. Therefore, it should be reduced first.

By actively making extra repayments on their family home, Jack and Sarah will not only reduce their debt, but increase their equity-further enhancing their financial position.


TIP BOX

• Equity is the difference between what you owe and what you own
• Establish a line of credit to access funds for a deposit
• Obtain pre-approval for a loan
• After buying, get final approval, borrow the full amount and reduce the line of credit balance to zero
• Reduce non-tax deductible debt first because it's more expensive.

Mark Armstrong and David Johnston are directors of Property Planning Australia propertyplanning.com.au