How does equity release work
What is and how does equity release work? Many investors misunderstand what leveraging, also known as equity release or gearing, actually means. At street level, the two words ‘leveraging and gearing’ are just fancy terms for debt. Debt that is taken on at a retail consumer level can be easily categorised and simply explained as either ‘good debt’ or ‘bad debt’. An example of ‘good debt’ is when you leverage or borrow against an appreciating asset such as property. Bad debt could be a loan against a car or credit card debt, classed as ‘bad debt’ because it is secured against depreciating assets.
If you own your home, it is likely financed by a mortgage, meaning you are leveraging the property to assist you with the purchase. This is very commonplace and makes complete sense because it makes purchasing property much more affordable. Describing this as leveraging would horrify some, although that is exactly what it is.
Some people buy an investment property because it is seen as an excellent income-generating asset class. With a reasonable down payment from the buyer and the rest mortgaged by a bank, the rental income generated from a tenant often pays the mortgage loan costs. Sometimes there will be surplus income for you to enjoy. This is an excellent use of leveraging or plain old debt.
Equity release to make further investments
You can accelerate this further. A property that has grown in value over time can often have a substantial difference between its actual value and the mortgage balance owed. By refinancing to a new lender for a higher amount and repaying the existing mortgage, you can release equity, giving you additional capital to invest elsewhere.
So what would you do with the cash? Some organisations tempt property owners to buy a new car or have a holiday of a lifetime. These two items may provide some wonderful memories, but that is about all. By using the cash sensibly, you can generate more income. Perhaps you might invest the proceeds to make a higher return than the interest rate you are paying on your mortgage. This is actually a reasonably high risk depending on the safety of your second investment.
A common way among property investors is to use the equity release as a deposit on another property. By mortgaging the remainder of the purchase value, you can finance 100% of the new property purchase. That should produce sufficient income to pay the debts whilst achieving further capital appreciation. Some will refer to this as smart gearing.
How does equity release work? A case study
Equity release is a financial instrument allowing you access to equity (cash) in exchange for your property’s value or partial value. How does equity release for the purchase of new property work?
As an example, Peter purchased a property in London 15 years ago for GBP 300,000, and it has now grown in value to GBP 750,000. There was originally a GBP 100,000 mortgage on the property, which is taken on an interest-only basis, is still GBP 100,000. Peter is now looking to purchase another property in the UK but does not want to use his liquid cash and investments and has instead contacted his mortgage broker to see if he can release equity.
After consideration, Peter can remortgage his existing property to a 65% LTV (Loan to Value) mortgage, i.e. GBP 487,500. This allows for the original mortgage of GBP 100,000 to be repaid, which leaves Peter with GBP 387,500 of cash to use towards a new purchase.
This allows Peter to purchase a new property with a value of up to GBP 1,100,000. The 35% deposit has been funded entirely from the equity release, whilst a mortgage has provided the remainder. In essence, Peter has managed to purchase a new property worth GBP 1,100,000 with 100% finance using the equity he had in his other property as security.
Releasing equity from a buy-to-let property
A buy-to-let property generates you a monthly rental income that, in theory, should pay off your mortgage on that property. Perhaps you wish to sell that property when you retire, but this will involve you having to pay Capital Gains Tax. Releasing equity on your buy-to-let property can offer you a tax-free lump sum, which you can then use to invest in another property or to provide you with your retirement needs.
Note that you should be able to release equity on your buy-to-let property as long as you show an ongoing tenancy agreement to the bank, and/or income to support the loan. Rent may still cover mortgage costs, but you now have a bigger mortgage, while you can use the fund from releasing equity to your advantage. Remember that any previous mortgage on the property must be paid off as part of the equity release process, and only then you can get the funds from the property’s equity release.
Related reading: A basic buy-to-let investment strategy
Is equity release for everyone?
Equity release on a property can be another way to consider when you’re thinking to build your property portfolio. If done correctly and with much consideration, it can be a great way to grow your wealth, however, there are things to remember if you decide to take this path. While a professional mortgage specialist has written this article, everyone’s circumstances are different, and we recommend contacting the team at Lifestyle for personal advice.
*This article was originally published by Andrew Wood and was recently updated in May 2021 by Elwira Skrybus and Gordon Franks from the Team at Lifestyle Property International*