Buying with Equity | Real Estate

If you’ve lived in your existing home for a period of years chances are you may have built a significant amount of equity.  If you purchased the home for $100,000 ten or fifteen years ago with a 20% down payment, your original mortgage balance of $80,000 may be as low as $70,000.  Australia has bucked the trend in other industrialized countries and home prices have continued to rise.  If your home today is valued at $250,000 you now have $180,000 in equity; sometimes referred to as the cash balance in your home.

Some financial advisors will tell you to use that equity to finance other real estate investments.  In our example above the homeowner with $180,000 could take out a second mortgage on his or her home and use the proceeds to buy additional real estate.

In theory, the homeowner could cash out all the equity and buy nine homes at $100,000 with a 20% down payment on each home!  In practice this strategy is highly risky and has led to the financial ruin of many unwary investors.  As a general rule of thumb, it is not a good idea to stretch yourself so thin that any change in the real estate market or the overall economy could wipe you out.  If our homeowner had bought those homes for rental properties and an economic downturn makes it difficult to find and keep renters, the homeowner is in serious trouble.

However, when implemented with proper risk controls, buying with equity can be a sound strategy.  First, you need the time and temperament to do this.  One highly desirable real estate investment is income property.  You use the equity in your home to buy a three or four flat building where two of the rents will pay the mortgage and taxes on the property leaving you with a little left over to use towards the second mortgage on your home.  But now you are a landlord, and that takes time.  While you have the option to hire a management company to act as property manager, that cuts into your profit margin.

Another investment option is to buy single family homes for renovation and quick resale at a profit.  You’ve probably seen the cable TV programs on “flipping houses” and while they look like an almost sure thing, they sometimes are just the opposite.  It can be difficult to bring a whole house renovation in within the budget necessary to make a profit.  Some investors who find themselves in this situation feel they then have to hold on to the renovated property as a rental to keep from taking a loss.  Now their equity is tied up in the second home instead of being available for other investment purposes.

Earlier we mentioned risk controls when it comes to buying with equity.  A financial advisor can provide you with fancy formulas but it all boils down to not borrowing more than you can expect to repay if your financial condition changes drastically.  There are ratios you can use which will tell you how much debt you can safely carry relative to your income.  If you buy rental property, the income is included in the ratio as is the additional mortgage.  For protection in emergencies, some experts advise you should have a “liquid” nest egg of 9-12 months of income.  Liquid simply means you can access the money quickly.  Real estate, as an example, is illiquid as it can take an extended time to sell a property to get your money out.  Certificates of deposit, bonds, and savings accounts are liquid investments.  Stock shares in the share market are liquid, but if you need the money at a time when the share market is in a down cycle, you may have to sell some of your holdings at a loss.