Get rich using your equity, but beware of the potential pitfalls

Homeowners are unlocking greater wealth and extra income by putting their biggest single asset to work. Here’s how.

The biggest way to build wealth for millions of Australians is sitting right on top of their head.

In fact, it’s their roof, and their surrounding walls and floor, thanks to the unique power and generous tax benefits given to home ownership.

For years home equity has been the most popular tool for people to become property investors. Others have used it to grow share portfolios, pay down debt faster or provide extra income.

Equity is the difference between the loan balance of your mortgage and the value of your property.

Over time the equity increases as the debt gets repaid and house prices rice, but some people can suffer from negative equity in property downturns when prices dip below their loan balances.

Catapult Wealth director Tony Catt said people could use equity in their home for both “good and evil”.

“They use it for evil to buy non-appreciating assets,” he said. Think cars, consumer goods or holidays where once the money is spent it disappears forever, or the item purchased drops in value.

Good use of home equity allows people to buy rental properties, shares or other investments where the interest is tax-deductible.

This strategy had slowed down as interest rates escalated since May 2022, Mr Catt said, but was still being used by the bank of mum and dad to help their children get into the property market.

Homeowners can multiply their wealth by using equity wisely. Picture: IStock

“Equity can help provide security for a bank and help the next generation out,” he said.

Mr Catt said he had seen a “significant” shift in the past year towards people paying their debt faster to combat higher interest rates.

A person’s own home is exempt from capital gains tax and Centrelink means testing, making it a unique store of wealth.

William Buck wealth advisory director Adrian Frinsdorf said in the past decade more people were unlocking home equity to invest, primarily to buy other properties.

“The ultra-low interest rate environment during this time was a key factor behind the trend,” he said.

“The rents being paid generally exceeded the interest cost to the property owner, with the tenant effectively helping pay down the owner’s loan. However, with the recent sharp rises in interest rates this is occurring less and less.”

Mr Frinsdorf said the Reserve Bank’s dozen interest rate rises since May 2022 had “definitely taken the gloss off this strategy for many Australian investors”.

“As the interest costs push well above the rental payments received, the shortfall becomes a significant impost, particularly for middle income earners,” he said.

“However, for high income earners the tax benefits are quite considerable so this strategy may still be appealing.”

Here are five key ways that home equity can help make you richer.

1 RESIDENTIAL PROPERTY

Interest rate movements can be short-term, but good property investments continue for many years or decades.

Today’s large loan sizes become relatively smaller as the price of property multiplies over many years. For example, Australia’s median capital city house price in 2003 was $355,000 and today it is $908,000.

Mr Frinsdorf said using equity to build residential property portfolios was a common strategy, and “some investors may also consider unlocking the equity to invest in commercial property syndicates, which can produce yields of 7 to 8 per cent”.

Financial services firm dmca advisory’s director, Tania Tonkin, said interest on investment loans was tax deductible.

“Therefore, the higher interest cost is offset to a degree,” she said.

2 SHARES AND OTHER INVESTMENTS

Ms Tonkin said people often focused on paying off their home loan ahead of investing, and this could slow their wealth-building elsewhere.

“It becomes a good opportunity to draw down on that equity and invest to diversify away from property by way of their principal residence, into other investments,” she said.

“Higher interest rates do make this less attractive, however the benefit of diversification and liquidity by investing in something other than the family home tends to outweigh this.”

Similar to property investment loans, borrowing to invest in a diversified share portfolio also delivered benefits, Ms Tonkin said.

“The interest on this loan is then tax deductible and you are effectively using the bank’s money to build wealth,” she said.

The price brackets househunters are looking … and aren’t on realestate.com.au

Higher interest rates make it tougher to get ahead, because dividends paid by shares currently yield around 4.5 per cent, below investment loan interest rates, so investors require capital growth to make an immediate profit.

Mr Catt said people who used their equity for investment should be sure to separate the investment debt from personal debt, as the Australian Taxation Office only allowed tax deductions on investment debt.

“And be conscious that you can stress test it to make sure it is at levels you can afford, he said.

“We have gone from an environment of talking about positive or neutral gearing, and we have gone back to negative gearing.”

Tax deductions for negative gearing mean a person is making a loss on their investment, as they only get their marginal tax rate back from the ATO – typically between 34.5 per cent and 47 per cent.

3 DEBT CONSOLIDATION

Using home equity to invest is not the only way to make money from it.

People who have room in their mortgage can consider consolidating high-interest personal debts such as credit cards – which can charge interest of 20 per cent – into a home loan with an interest rate near 6 per cent.

However, when consolidating debt, it is a good idea to destroy the offending credit card, store card or other loan to prevent yourself from racking up the bad debt again.

And aim to make more than the minimum repayment on the mortgage – otherwise you are turning a short-term consumer debt into a long-term debt spanning 20 or 30 years where the overall interest paid will be much higher.

4 OFFSET ACCOUNTS

Extra home equity has short-term benefits for people who use offset accounts rather than keep spare cash in a bank account.

An offset account is a transaction account where the balance sits against the principal of your home loan, reducing the interest cost and paying down the debt faster.

Ms Tonkin said this strategy often required discipline. “If using an offset account that builds up, it may be tempting to spend more than your budget if the cash is readily available,” she said.

“Use an offset account to collect salary and wages during the month to reduce the interest component of monthly home loan repayments, therefore directing more towards reducing the original loan amount.

“Use a credit card for monthly living expenses, but make sure this is paid in full by the due date to avoid any interest costs. That way salary and wages are working for you during the month to reduce interest costs on your mortgage.”

House prices have surged in the past two decades, boosting home equity. Picture: iStock

5 EQUITY RELEASE FOR SENIORS

Australians are living longer and many are asset-rich but cash-poor.

Home equity can be used here, too, through reverse mortgages that enable seniors to draw back on their asset, although many shy away from the idea of taking on fresh debt in retirement.

“I see reverse mortgage options as risky as the rates applied to these are usually a lot higher than typical home loan rates, therefore I don’t usually recommend this option,” Ms Tonkin said.

“The compounding effect of interest accruing over a number of years on the loan amount can escalate the erosion of any equity in the home,” she said.

Reverse mortgages had protection built into them to prevent people owing more than their home was worth, Ms Tonkin said.

“The government also provides a Home Equity Access Scheme, where if eligible for age pension, you can increase your fortnightly pension payments by up to 1.5 times,” she said.

“This additional amount paid is treated as a loan from the government with interest accruing at a statutory rate.”

Mr Frinsdorf said unlocking equity to boost retirement funding was an important decision “so it’s best to speak with an experienced adviser first to determine the right strategy for your specific circumstances”.

PROTECT YOURSELF

Using home equity for investment loans ultimately puts your home at risk if the investment crashes to zero and you cannot afford repayments, so it’s crucial to diversify investments and have wiggle room to cope with sharp rate rises.

It is also important to have income protection insurance in place is case you lose our ability to work.

Mr Frinsdorf said it was prudent to have a plan to cover debt management and repayment.

“Investors are often good at planning for the accumulation of assets, but the associated debt management side does not always receive the same consideration, when it is equally as important,” he said.

Originally published as Get rich using your equity, but beware of the potential pitfalls