The truth about using equity as a deposit

How to use equity in your own home as a deposit

If you bought a home a number of years ago, you may well have a decent chunk of accrued equity. You might also be thinking about using this equity as a deposit for future property deals. It’s a simple idea that property investors casually throw around in conversation. But how do you go about doing something like this and what are the keys to getting it right? We’ll take a look at all this and more in this post.

A worked example

Assessing the equity available

This strategy is relatively straightforward and it’s easy to execute. Let’s take a look at a simple example. Let’s say you and your family bought a home ten years ago for £120,000. You used a 75% loan-to-value repayment mortgage to finance the deal at a 2% interest rate with a term of 25 years. That means you put down a deposit of £30,000. You also took out a mortgage of £90,000, which you’ve been paying down since.

Ten years and 120 mortgage payments later, the property has seen good capital growth. Its market value is now estimated to be around £180,000. In addition, we’ve been making monthly repayments against the loan. So, the amount we owe has decreased from £90,000 to £60,000. Taken altogether, that means we have £180,000 − £60,000 = £120,000 of equity accrued in the property. We can potentially use some of this to finance future deals.

Pulling out the funds

In order to pull out the cash to invest, we’ll need to remortgage. Let’s build off the example above. Suppose we decided to remortgage the property based on the £180,000 valuation using a new 75% loan-to-value mortgage. This would leave 25% × £180,000 = £45,000 of equity in our property. We would take out a new loan for 75% × £180,000 = £135,000. We repay the £60,000 outstanding loan amount on the original mortgage. This leaves us with £75,000 of cash in our bank account to invest in new property deals.

The impact of the remortgage

That’s the easy bit over with. The harder part is understanding whether it makes good financial sense to use the equity we’ve accrued in this way. To understand this, we’ll need to do a few more calculations.

Impact on our mortgage repayments

When we went through the remortgage, we increased our outstanding loan from £60,000 to £135,000. That is, we borrowed an additional £75,000. As a result, our mortgage payments will have increased. You can use your favourite online mortgage calculator to check the following figures are correct. We have one available on the Essential Property website here. However, the refinance will increase your mortgage payments from £382 per month to £572 per month, assuming we’re still able to secure a 2% interest rate (the same as the original loan) and that we respread the £135,000 loan amount after the remortgage over a new 25 year mortgage term starting at the refinance date. That is, our monthly mortgage payments will increase by £190.

The returns from investing the capital raised

Let’s take a look at the other side of the coin, i.e. what we’ll do with the money raised. Well, if we invest the £75,000 of cash raised in buy-to-let deals that generate an ROI of 6%, then your new investments will generate 6% × £75,000 = £4,500 per year or £375 per month before tax. Overall, we’ve been able to improve our cash flow by £375 − £190 = £185 per month. This is before we take tax into account. In addition, because we’ve taken out a new repayment mortgage, we’ll again be building up equity in our home afterwards.

We also have a bigger property portfolio

Finally, it’s also worth noting that by using the equity in our own home in this way, we’ve also been able to expand the size of our property portfolio. Before the remortgage, we owned one property worth £180,000. Afterwards, we might own additional properties worth £75,000 ÷ 0.25 = £300,000. That’s the case if we bought the extra buy-to-let properties using a 75% loan-to-value mortgage. So, the total value of our portfolio is now £480,000. We’re more leveraged, of course. However, this increase in the size of our portfolio positions us nicely if property prices continue to rise in the future. This strategy has the potential to seriously increase our net worth over the long term.

Keys to success

As with all of these strategies, there are things you need to do to get it right. Here are a few of the keys to success for this approach.

Make sure your partner is onboard

Anything to do with your own home has the potential to be emotive. You should make sure your partner is onboard with this strategy and that they understand the benefits and risks it can bring. If they’re struggling with the concept, you could always consider taking out less equity.

Getting confident with the numbers

The figures we looked at above worked because the ROI we were projecting on the new investment was high enough. To make this worthwhile, you need to get confident that the ROI you can achieve is significantly in excess of the interest rate on your mortgage.

Getting comfortable with debt

This play only works if you’re comfortable taking on extra debt and increasing your leverage. It’s best to avoid this play in the latter stages of the property cycle. This is because the ROI on new investments will likely be low at this stage in the cycle.

Use a good mortgage broker

I would always recommend using a mortgage broker when you’re refinancing any deal. However, they can be particularly useful with this strategy. They can help you get the best rate and explore the impact on your monthly cash flow of various loan-to-value options.

Watch out for early repayment charges

When you remortgage with a new provider (as opposed to a product transfer with your existing lender) you’re using the new loan to pay off the previous lender. If you’re still in your fixed-rate period, you should watch out for any early repayment charges.

Using equity as a deposit – Reversal

There are times in life when this approach is not the right one for some people. If you’re later in life and your children have flown the nest, you may be better off selling the property, locking in those gains, and then downsizing your home. With new mortgage products coming on to the market all the time for those later in life, you might still be able to get a mortgage on your new home purchase, and it could unlock even more funds to plough back into future investments.

Likewise, if you’ve got a young family and might soon need a bigger place, you may want to use the equity you’ve accrued as a deposit on the new home instead. Although the cold calculated, numbers-driven investor in me is at pains to admit it, there are times in life when other things are more important than making an optimal investment decision. Starting a new family and bringing children into the world are certainly amongst them.