Using home equity to invest is a powerful investment strategy, but it is not suitable for everyone. In this case study, we compare buying an investment property with home equity against buying one without it, so your clients can see the differences in timing, tax paid, debt levels and cash flows, and make an informed decision.
In this case study, Cynthia and Tony, want to purchase an investment property. They do not have a deposit saved, yet, so they are considering whether to use the available equity in their family home so they can buy the property immediately. To help them decide, we will compare:
- Scenario 1: Purchasing the property immediately at a value of $400,000. To fund the purchase, 20% of the property value (i.e. $80,000) is borrowed against the home and 80% of the property’s value (i.e. $320,000) is borrowed against the property itself; and
- Scenario 2: Purchasing an investment property once they have saved enough to cover the property’s deposit and acquisition costs. To fund the purchase, 80% of the property’s value is borrowed against the property itself and no home equity can be used.
We will also make the following assumptions:
- New investment property: Valued $400,00 in 2018/19 dollars, then indexed by 2.5%pa;
- Investment property loan:
- Principal and interest loan
- Interest rate 5.8%pa
- 25-year term
- Home equity loan:
- Principal and interest loan
- A lower interest rate of 5.2%pa
- 25-year term
- They have a home with an outstanding mortgage
- They would like to keep a $10,000 cash reserve
- Savings for the deposit and acquisition costs must be made in cash
- Any excess funds not required for the home purchase or other expenses can be saved in a joint balanced fund outside super with 2.13%pa capital growth and 3.68%pa income (including franking credits and after fees)
- CPI 2.5%pa
- AWOTE 3% pa.
The following results show Cynthia and Tony different aspects of their strategy, which can help them decide which strategy works best for them.
Projected net wealth at the end of the analysis
After 20 years, it is projected that using the equity in their home to purchase the property immediately will increase Cynthia and Tony’s net wealth by about $35,000 (present values) more than if they waited to purchase the property later when they have saved for a deposit.
However, that is not the end of the story. Further analysis into the detailed cash flows gives insights into other factors that contributed to the outcomes.
Property purchase year and actual value
If Tony and Cynthia save up their deposit and acquisition costs, then it is projected that the earliest they can buy the property is 2021/22, or three years later than buying the property immediately. Furthermore, we have assumed that the property value grows by 2.5%pa, so by the time they make the purchase, the value has increased from $400,000 to about $431,000, and the 80% that they borrow against the property has increased from $320,000 to about $345,000.
If Cynthia and Tony have an opinion about the future of property prices or interest rates, knowing that they will need to wait at least 3 years to save a deposit may help inform their decision about which timing works best for them.
Total debt levels
This chart shows Cynthia and Tony’s total loan balances outside super, which consists of their home mortgage and the new property loans.
For the first 10 years, their debt levels are higher in the first scenario because they borrow more and borrow sooner. However, this head start ultimately means that in 20 years’ time, their debt levels will be lower.
Tony and Cynthia can also see that if they purchase their property immediately, then their debt levels in 2018/19 will be about $608,000, rather than about $211,000 (which is just their home mortgage). This gives them specific information to help them decide if they are comfortable with the level of debt they would need to take on at this time.
Minimum annual loan repayments
Their total loan repayments are about $3,900/year higher when they borrow against their home. In scenario 1, their total mortgage repayments are about $29,998/year and consist of $24,274/year for their normal mortgage and $5,724 for the home equity loan. In scenario 2, their total mortgage repayments are projected to be about $26,140/year.
It is also worth noting that it is projected that the scenario 2 repayment is higher than the normal mortgage in scenario 1 because even though the 80% LVR is the same, the property value has increased while they were saving, so they need to borrow more against this loan.
This chart shows the difference in total tax paid outside super, including personal tax, Medicare levy and deductions from the property loan interest repayments and property expenses.
Comparing the strategies, we see that when purchasing the property immediately, their combined tax paid from 2018/19 until 2021/22 is less than that for the alternative strategy. This is because interest paid on the investment property's loan and the home equity loan, as well as running expenses, are tax deductible.
Available cash for other investments
By using the equity in their home, Cynthia and Tony do not have to put aside excess funds to save for their property deposit, so they can direct more funds into alternative investments sooner.
The following chart shows the deposits to their new balanced fund when the property is purchased immediately. Once the property is purchased in the first year, they have enough excess cash to make deposits of around $20,000 a year.
The following chart shows the deposits to their new balanced fund when the property purchase is delayed. No significant deposits are made until 2022/23, after the property is purchased.
This chart shows their cash balances while they are saving for the home deposit in scenario 2. It drops to their $10,000 reserve in 2021/22 when they spend it on their property purchase.
At the end of 20 years, the projected balance of this investment is $1,092,000 for scenario 1 and $1,078,000 for scenario 2. So the different schedules of deposits boosts the balance in scenario 1 by about $14,000 (present values).
Although, in reality, Cynthia and Tony may not wish to direct all their excess cash to this fund, it illustrates how much excess cash they have and when. It also shows the impact of being able to deposit more funds in an investment with a higher return sooner or later.
To help Tony and Cynthia decide whether or not to use the equity in their home to fund their new investment property, it is useful to show them how each scenario affects the timing of their purchase, debt levels, mortgage repayments, tax paid and excess funds, and the effect of these on their longer-term net wealth.
This can easily be done in Optimo Pathfinder using our new ‘Special borrowing’ feature and explained with our improved comparison charts.
This is a case study and only contains general information, so it should not be used as financial advice because it uses sample data that cannot reflect an individual’s real and complete circumstances.
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