Equity – the difference between what your home is worth and how much you owe on it – is a crucial concept in property investment. The Successful Investor’s Michael Sloan explains how you can use ‘The Rule of Four’ to your advantage.

Give me the main points

  • Equity is what proportion of your home you own (its value less the mortgage).
  • Useable equity is what proportion you could use to buy another property.
  • Typically, banks will lend up to 80% of the value of a property.
  • Rule of thumb? You can afford an investment property that’s four times the value of your useable equity.

Equity is the difference between the value of your home—and how much you owe on it. Your stake… and the bank’s. So if your home is worth $400,000 and you still owe $220,000, your equity is $180,000.

The great thing about equity is that you can use it as security with the bank and borrow against it:

  • to extend your home
  • to start a business
  • to buy a car
  • to go on a holiday, or
  • for any other use the bank allows.

Most importantly, you can use the equity in your home to buy an investment property.

Total equity and useable equity

Keep in mind you can’t use all your available equity. Since the bank is lending you money against the value of your home, they won’t lend you the full amount. Why? Because if house prices dip, they don’t want to an outstanding loan that’s worth more than the asset (the customer’s property).

Typically, banks will lend you 80% of the value of your home, less the debt you still owe against it. Consider this your useable equity. However, it’s possible to borrow more than 80% if you take out Lenders Mortgage Insurance (LMI).

How much can you borrow?

Let’s do the sums using the example above. Your home’s valued at $400,000 and your mortgage is $220,000:

Banks will usually loan you up to 80% of a property’s value:

Value of your property $400,000
Value of your property @ 80% $320,000
Minus your mortgage $220,000
Useable equity $100,000

So what value investment property can you buy?

Well, a simple rule of thumb is to multiply your useable equity by four to arrive at the answer. Four x $100,000 means your maximum purchase price for an investment property is $400,000.

But why multiply by four (and not five)?

If you’re buying an investment property worth $400,000, the bank will lend against your future property just as they would against your existing home. As we know, the banks will lend 80%, or $320,000 in this scenario—but this property costs $400,000. This leaves an $80,000 gap, which is your deposit.

However, you also have to budget for purchase costs such as stamp duty, legal fees and so on. This works out to around 5% of the purchase price, ie. about $20,000 on a $400,000 property. Therefore, the total amount of funds required to purchase a $400,000 investment property is now $100,000—an $80,000 deposit plus $20,000 costs.

So if you multiply $100,000 by four, you get $400,000. That’s what you can afford.

One more thing

You may have heaps of equity but it’s not a given you can borrow against it. The bank takes into account your income, your age, how many kids you have, your additional debts and a host of other factors. Before you get serious about investing, talk to your banker or broker.

But above all, remember to play safe. If you don’t have any funds outside your home equity, then it’d be risky to use every last cent of your usable equity to invest in property. You always need a buffer, some funds in reserve in case things don’t go to plan. Even if it means you can’t invest for a while, it’s important to keep yourself protected.

Disclaimer

The information in this article has been written by Michael Sloan from The Successful Investor. While Mr Sloan has been careful to ensure the information is correct and accurate, Mr Sloan’s views are his own and do not necessarily represent those of National Australia Bank Limited ABN 12 004 044 937, AFSL and Australian Credit Licence 230686 (NAB). This information should not be relied upon as financial product advice as none of the information provided takes into account your personal objectives, financial situation or needs. NAB recommends seek the counsel of an independent financial advisor before making any investment decision.

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