Are you looking to shift your primary residence or want to purchase an investment property without exhausting your savings?
In step, home equity & leverage.
Table of Contents
In this blog post, we break down how to use home equity to buy another home or investment property with a home equity line of credit, and how that will equal more wealth in the long run. It’s true – more debt can equal more money!
To help you better understand how leveraging home equity actually works, we break down a couple of other concepts that we think are extremely important.
Using Home Equity To Invest In Canada: Key Concepts
Good Debt Vs Bad Debt
Though the words ‘debt’ and ‘borrowing’ carry a negative connotation and a lot of risks there is such a thing as good debt, too.
Good Debt: Good debt increases your net worth and/or helps you to generate value that’s beyond the reach of your present income. Example: homeowners taking out a new mortgage to buy a new home, borrowing student loans, or accessing a line of credit for debt consolidation
Bad Debt: Bad debt on the other hand typically uses borrowed money to purchase goods or services that have no lasting value, like a fancy car or material items you don’t plan on reselling. Example: Money borrowed from credit cards, payday loans, etc.
Don’t get us wrong, we love toys and shiny things as much as the next person, but from an investment standpoint, they aren’t going to bolster your financial portfolio. Good debt isn’t something to worry about financially, and can actually be a great asset if used correctly by borrowers.
What Is Home Equity? How Is It Calculated?
Home equity is the current market value of your property. In simpler terms, it is the money your home is making for you. It’s calculated by estimating the potential property value minus any mortgages or other loan amounts from it. Your home equity can always be used a collateral to raise money in the form of home equity loans or home equity lines of credit. The longer you hold a property, the more equity you will earn.
Home Equity = [Fair market value of home] – [Mortgage balance]
For example, let’s say you bought your current home for $400K. Since buying it, you’ve managed to pay $150,000 towards your existing mortgage loan and it has appreciated in value by $200K over the last few years. The fair market value (FMV) of your home will be $600K. The equity in your home is the amount that you would receive if you decided to sell your home and pay off the remaining mortgage; in this case, the equity equals $350K ($600K (FMV) minus $250K remaining mortgage).
Note: To calculate your home equity, you can use an online home equity loan calculator like this one from CIBC.
What Does Leveraging Your Home Equity Mean?
In simple terms, it means to use borrowed money to increase the potential return on investment. So with that in mind, how to use leverage in real estate is actually quite easy. You can leverage the equity in your home by borrowing funds on the fair market value of your current home. Chances are your home has increased in value since you purchased it. While you may have only paid down a portion of your mortgage to date you are still able to borrow up to 80% of the fair market value of your home, minus any outstanding mortgage payment due. Leveraging the equity in your home into additional properties is the trick. More on that later.
Two Peas in a Pod: Using Cash Vs Home Equity To Invest
To demonstrate the effects of leverage on equity, let’s use the example above, but split it into outright cash vs. leverage scenario:
• Using cash to invest in real estate in Canada: Buy a $500K property using all cash.
• Using home equity to buy another home in Canada: Buy a $500K property with $100K cash and a $400K loan.
If and when the property appreciates to $600K the following year, what happens?
• Using cash to invest in real estate in Canada: Return on equity = 20% ($100K increase on a $500K investment).
• Using home equity to buy another home in Canada:: Return on equity = 100% ($100K increase on a $100K investment).
By using leverage, not only do you outlay less cash but you also get a much higher (5x to be exact) return on equity. Now that we’ve broken down how you can benefit when you borrow money and leverage a property instead of paying cash down, this might be a good time to download our Guide To Investing In Pre-Construction Real Estate.
Home Equity Loan vs Home Equity Line of Credit (HELOC)
- Home Equity Loan: A home equity loan is a fixed amount of money paid upfront in one lump sum. As a borrower, you will start paying interest on the loan the moment you take it out. On average, the home equity loan rates in Canada are slightly higher varying between: 6.9% – 9.5%. As of December 2022, the interest rate stands at around 7.7% – with slight differences based on the terms of the loan.
- Home Equity Line Of Credit (HELOC): A home equity line of credit on the other hand ensures that you only pay interest on the funds you use as you use them. On average, the interest rates for HELOC is slightly lower – though it varies. As of December 2022, the average HELOC rate is around 7.3% – which generally hovers between 6.3% – 8.5%.
Borrowing on a higher interest rate vs a lower interest rate can make a big difference when it comes to purchasing a pre-construction condo with borrowed funds. The added risk often makes or breaks an investment. Unlike re-sale where you put down a 20% down payment upfront, pre-construction is paid in installments – typically 15% in three installments over the first year with the final 5% paid approximately 4 years later upon completion.
In case this is something you want to know more about, we have an entire blog Comparing Home Equity Loan vs HELOC.
Using Home Equity To Buy Another Home In Canada
Can You Use Home Equity To Buy Another Home In Canada?
Yes, you absolutely can! In fact, you can use your home equity to invest in pretty much any asset – it need not be another home or real estate property for that matter. Personally, my advice is to look at lucrative investments that turn into exponential returns when using borrowed money.
Why Do People Buy A Second House In Canada?
Purchasing a second home is becoming a very popular choice in Canada. Different goals drive different individuals. Below are a few popular reasons why people choose to purchase a second home in Canada:
A vacation home or cottage to blow off some steam over the weekends
A house or apartment equipping the children for the future
A place to reside suited to a life in retirement
To welcome or accommodate new family members in a bigger location
Unforeseen circumstances that lead to a need for downsizing
An investment opportunity for the long-term
A major life event that requires you to relocate
Can Anybody Buy A Second Home In Canada?
Well, almost. As long as you’re a Canadian individual you should face no trouble buying a second home in Canada. Of course, as a borrower, you will still need to have a good credit score, pass a stress test and pass any other checks requested by the financial institutions. As long as you’re buying your second home to live in or are using it as a multi-unit (you live in it while renting out part of the unit), your second mortgage will look pretty much like the first one. The amount of the down payment will differ depending on the particulars of your new home.
If you’re thinking of purchasing additional properties in Canada as investments, just be wary. For starters, the requirements to get a mortgage as an investor and homeowner differs. Do your own research in advance and don’t rely on the experiences of your first mortgage. Also, as per a new rule passed on 1st January, 2023, some foreigners are no longer allowed to buy residential properties in Canada for investment purposes till 2025.
Benefits Of Using Home Equity To Buy Another Home In Canada
Appreciating equity value: As the property you bought appreciates over the years, it becomes worth much more than the monthly mortgage payment made. Even if you don’t want to sell it, you can still use the value it has generated over a period of time to purchase a second home. As a homeowner, you can use your home’s appraised value to make the down payment for another property, be it a vacation home, a second home, a rental property or otherwise. Using the equity in your home to invest in real estate and generating more returns makes more economic sense than simply letting it sit around and allowing that added value go to waste.
Opportunity to earn additional rental revenue: Some people use home equity to buy a second home in Canada or vacation home for recreation while others do it for investment purposes. In any case, before you actually use your equity, it’s important to carefully weigh your other options, whether you’re buying a vacation home or a property to generate a steady stream of rental income. If you are looking to buy a rental second property, remember that a condo will give you the highest returns on your investment. Currently, scarcity in the housing market has led to low vacancy rates, which in turn has led to a good appreciation of condos (more on this in the last section). No matter what type of housing option you’re considering, be sure to get an estimate of the price of the property you’re looking to buy your home’s equity.
How Does Equity Work When Buying A Second Home?
So, by now you’re probably starting to think that this whole leverage business makes a lot of sense but — the question of the hour — how do you make it work for you?
Obtain leverage at a low-interest rate: Well, when you own a property and you have equity built into your home, you’re allowed to leverage home equity (i.e.borrow that home equity, meaning that mortgage providers will let you refinance or re-draw up to 80% of the market value of your home) for a nominal, low-interest rate.
For example, if your house is worth $500K, a lender will let you borrow $400K (minus any current mortgage amount outstanding).
Approach financial institutions for Home Equity Line Of Credit (HELOC): It’s easy to obtain leverage if you’ve amassed equity in your home or a property that you already own. You simply need to approach your bank for a home equity line of credit, also known as a HELOC loan. You can then use this HELOC to leverage your home equity to buy another home in Canada or to buy a rental property. You can use equity to buy another house.
Let’s take the $400K property from above and let’s say you still owe $200K on your mortgage. In this scenario, you can still borrow $200K (from 400K – 200K), at roughly 3% or $6K each year, which over five years would amount to $30K.
Use HELOC to purchase your second property: At this point, you can invest that $200K into a rental property, which will accumulate its own equity over time to more than make-up for the $30K extra you will need to pay in interest on the initial loan. And, as a cherry on top, the Canada Revenue Agency (CRA) allows you to deduct the interest portion of your investment property mortgage from your taxes, so it’s a win-win.
When it comes to this setup, the more properties you add the more complicated the math becomes, but you get the idea: more leverage leads to more equity leads to more money in the long run! By using leverage, you increase your ability to purchase high-value investment properties which subsequently increases your net gain as property values appreciate. You can keep using home equity to buy another home and continue this cycle.
If you still feel using your home equity to buy another home or invest in Canada is not a viable option, there are some alternative financing options that you can consider!
Finding the Best Condo Investment in Toronto
Traditionally over the last 15 years, the majority of people who have invested in pre-construction Toronto condos have made a lot of money doing so. The ability to leverage a small amount of money over a longer period of time has proven to be a successful investment strategy and we’ve been conditioned to believe that this is the best way to make a great return. But the real estate market is exactly that — a market. And the market is changing every day.
If you are interested in using equity to buy a second home in Canada, read our latest post: Finding The Best Condo Investment In Toronto.
Disclaimer: It’s important to note this is a financing tool to get ahead faster. This is not a suggestion to take out all of the available debt to you and spend it on a whim. You must budget correctly otherwise you can get yourself into trouble