Updated: May 18
Creating additional wealth for your future while you still have a mortgage can seem like an impossibility.
But you feel as though you have equity in your home and have heard about putting this hard-earned equity to work for you.
But how does it work?
For starters, Equity is the difference between the value of your home and the balance of your mortgage. If your home is worth $900,000 and you owe $500,000, you have built up $400,000 ‘equity’ in your home.
Equity in your home essentially allows you to borrow money, using your home as security, to allow you to invest this money into growth based assets. This may be another property or a diversified share portfolio for example.
The key idea is that what you borrow to invest into will grow over time (say the next 10 years) and, if you make interest-only repayments on the loan, the loan will stay at its original balance. At the end of 10 years the investment is hopefully worth considerably more than the original loan balance and therefore could be sold down, pay the bank back and you make a good profit.
The other benefit of using the equity in your home in this way is that not only would you expect a good quality growth asset (like shares or property) to grow in capital value over time, but along the way you would expect the asset to pay you an income or ‘yield’ to help cover the interest costs on the loan and associated investment costs.
Ideally, if you invest in a smart way, the income or yield paid to you will all but fully cover the interest and costs involved and therefore you aren’t out of pocket month to month. If you are out of pocket however, this is then known as ‘negative gearing’ and you can claim any net deficit each year as a tax deduction and you will likely get a portion of that deficit back from the tax office.
Therefore, using equity in your home to invest should cost you little out of pocket month to month, but over the long term see you make a great profit or capital gain.
What do I need to be aware of?
Growth investments, like property or shares, are great at increasing in value over the long term – but in the short term they can often be volatile (go up AND down in value temporarily). This can be worrying for someone who doesn’t understand the normality of this. It is also dangerous for someone who only intended to be in this investment for a short time. It is important therefore to ensure that to embark on this strategy it can’t be for the short-term but for the long-term investor who is willing to be thick-skinned during market volatility.
Interest rate risk
If you use the example above, whereby you pay interest only on the investment loan to keep costs down, unless you opt to fix the interest rate on the loan, the rate of interest can go up and down during the life of the loan. This can potentially make the out of pocket cost each week increase and potentially make the investment unaffordable, forcing you to sell before you had planned to. This is where fixing interest rates can be beneficial to reduce this risk.
Be careful of poor investment decisions
It’s important that if you are going to use the equity in your home to borrow to invest – that you invest in a sound and reliable investment. Investments can be excellent and go up considerably over time – but the reverse is true too whereby poor investments can fall considerably and not recover.
If you aren’t an expert, it can pay to seek professional help from a financial adviser to guide you in this process. One of the best guiding principles for smart investing is ‘diversification’ (not putting all your eggs in one basket).
A real opportunity
In summary, if you are sitting on equity in your home, this presents a potentially wonderful opportunity to increase your wealth in a cost effective and tax efficient manner. Seek advice on how this might work for your particular situation. At Clarity we specialise in this stage for the right people and would be more than happy to discuss this with you.