Home equity

What is equity? How much equity should I have in my home or investment property? How does equity fluctuate? What does ‘negative equity’ mean and could it affect me? Strap in for answers to all the questions you never asked.

What is equity?

Say you own a 100sqm rusty tin shed with no ceiling in the trendy, inner west Sydney suburb of Marrickville. Your shed is worth a cool $3m – because life is unfair. Say you have a mortgage on that shed worth $2.4m. Your equity stake is $600k. This is your ownership interest. This means 80% of the value of your shed is debt and 20% is equity. A lawyer will tell you that your equity stake in your property is 100% and that a bank has a ‘security interest’ over the entire property. Don’t listen to lawyers, lawyers are boring. Although technically true, we’re concerned with numbers and the power of your actual equity stake. Practically speaking, your equity stake is 20% or 600k.

How much equity should I have in my property?

A minimum of 20%. You may be able to find a lender willing to lend to you with less than a 20% deposit. But you should be aware of the risks, of which there are many. Purchasing a property with a less than 20% deposit may attract the imposition of LMI to your loan (see Buying your first home – Part 1 of 2). Purchasing a property with a less than 20% deposit in Australia as a first home buyer under certain government schemes also carries risk (see Buying your first home – Part 2 of 2). For what it’s worth, I personally don’t condone making the biggest financial decision you will ever make with less than a 20% equity stake without having first sought informed and trustworthy advice.

How does equity fluctuate?

Your equity increases as you pay down your mortgage. If you make extra repayments and pay down the principal more quickly, your equity stake rises more quickly. On the other hand, as interest accrues on your mortgage, your equity stake falls. Fluctuations in the value of your home also impact your equity. Let’s continue with the shed example above. Say the bank does an independent valuation on your shed and discovers it’s worth $3.3m. You absorb that entire benefit. Your equity stake increases from 600k/3m (20%) to 900k/3.3m (~27%). However, equity fluctuations can also work against you. If your shed falls in value to $2.7m, your equity stake is now only 300k/2.7m (11%). If it falls to $2.4m, your equity stake is nil. And what happens if it falls below $2.4m? Bad things. This is what we call ‘negative equity’.

Negative equity

If you owe the bank more than the value of your home, you have negative equity. In this scenario the bank is within its rights to demand that you put up more equity to protect the value of its loan book and failing that, it could actually force you to sell your home and pay back the mortgage. You can protect yourself against negative equity. The smartest way to do this is to ensure that you don’t borrow irresponsibly. Borrow within your means and make sure you have a sensible deposit which gives you an equity buffer and protects you against the worst-case scenario. Between 2017 and 2019, Sydney house prices fell ~14% and it feels like no one even noticed. If in 2017 you’d purchased an $800k house with a 5% deposit, then by 2019 you would have -9% equity. Your house would have been worth $688k and your loan about would have been $760k (assuming no interest gains and principal repayments). Borrow responsibly and borrow when you’re ready, not when the bank or the government says you are.

Bonus fact

Aussies are some of the wealthiest people in the world (not millennials, we’re pretty screwed). How did they get so rich? Most Aussies actually owe their success to this concept of home equity. They purchased homes many years ago and accumulated equity by paying down their mortgages and more importantly, by experiencing eye-watering house price growth. This gave Aussies financial power. In the world of shares, when you invest in a company and experience share price growth, your capital gains aren’t actually realised (or crystallised) unless you sell your shares. Until this time, they’re called paper gains and there’s not much you can do with these paper gains. Most lenders won’t use these shares as security for anything because shares tend to fluctuate in value on a daily basis.

Property gains also don’t crystallise until the point of sale. However, once you experience decent growth in the value of your property, banks actually let you tap into these unrealised equity gains to finance the deposit of a second or (if you’re a baby boomer), eleventh property. You are of course still limited by your borrowing capacity – the bank won’t lend you infinite money. Continuing again with the shed example, if your shed rises in value to say $3.5m, your equity stake is now 1.1m/3.5m (~31%), when you only need $700k in equity (20%) to avoid LMI. This means that (if your borrowing capacity allows), the bank will be willing to extend you $400k to fund the purchase of a second property. How long will it take you to save $400k?

This is absolutely a legitimate get-rich-quick scheme if you’re an informed investor and if luck is on your side. If however you’re not carefully doing your DD and if luck isn’t on your side, it’s a one-way ticket to bankruptcy. Even if you’re wise and you only move forward with a 20% deposit, what if you have 5 investment properties in your portfolio and the housing market crashes >20%? And the bank demands extra equity? What if house prices don’t change but a couple of your properties remain untenanted for a few months, seriously impacting your ability to make your repayments?

Food for thought.

P.S. birks are the worst.