One of the perks of homeownership is being able to build up equity in your property every time you make a mortgage payment – and over the years, the equity you accumulate may open opportunities for you to grow your wealth even further by allowing you to apply for a home equity loan.
But what is home equity and how can you tap into it? Can you use a home equity loan for anything? What are the benefits and drawbacks of releasing your equity? Here are some important things you need to know about taking out a home equity loan.
- What is a home equity loan?
- How to access your home equity
- How much equity can you borrow?
- How can you build equity in your home?
- What can a home equity loan be used for?
- Is a home equity loan right for you?
- Downsides to a home equity loan
What is a home equity loan?
Put simply, equity is how much of your home you actually own. The equity in your home represents the difference between the current value of the home and how much is owing on the mortgage. You may have purchased your property for, say, $300k, but over the years the value of the property on the market could have doubled, so your home is now worth more than what you might have thought.
As an example, say your home’s value now sits at $650k, and you still have $350k to pay back on the mortgage, which means you own the remaining $300k – this is your raw equity.
A home equity loan is a type of mortgage that allows you to borrow against your equity. Banks and other lenders will often allow you to use equity as security so you can borrow money through a home equity loan.
How to access your home equity
There are several ways you can access the equity in your home, which include the following. Note that not all of these options may be available to you.
Line of credit
A line of credit acts a sort of credit card for your house, where you can access some of the existing equity you’ve built up in a property. A line of credit is a form of revolving credit which has a pre-defined limit based on your available home equity, which is determined by your lender. This will give you the flexibility to borrow up to the pre-defined limit, repay, and reborrow against the available line of credit over the draw period.
A loan borrowed against a line of credit is usually charged with a variable interest rate. The repayments for this type of home equity loan vary as they only depend on the amount actually borrowed.
For instance, Helena has applied for a line of credit worth $100,000. When she gets the approval, she has the option to use all of it at once. This would work well if she were to invest in a property. On the other hand, she could opt to use only a portion of the line of credit — she can draw down $20,000 for a small investment and interest will only be charged on that amount.
If she were to use a further $50,000 for house renovations, for example, then she would be paying interest calculated on $70,000 ($50,000 for renovation + $20,000 for investment). This leaves her with an available balance of $20,000 in her line of credit that she can use later if needed.
Some lines of credit will allow you to capitalise the interest until you either reach the limit of the line of credit, or a set percentage of the limit. This means that the repayments can be added to the amount already drawn down.
Lines of credit are, by their nature, interest-only, with equity being built up through your putting funds directly back into the facility.
They are usually more expensive interest rate-wise, and will often have a monthly, half-yearly or annual fee attached to them. This may be from $10 per month to $600 per year, though most are in the $120–350 per year category.
There are significant differences between products in the market. Some remain interest-only for an initial period, say 10 years, and then turn into an amortising principal & interest loan. Be sure to consult your financial advisers before making any major decision regarding the equity you’ve built up in your home.
A lump sum home equity loan works like a typical home loan where you borrow an approved amount and make the necessary repayments – including interest – over a certain period.
Typically, a lump sum home equity loan has a fixed rate that can run from five to 15 years. You should be able to pay back this loan in full before you can sell your property.
Refinancing is one of the most common ways to access the equity in your home. You can either refinance with your current lender (internal refinancing) or refinance with a new lender (external refinancing). Before you refinance, your home will need to be revalued to determine its current worth. If the property has risen in value since you bought it, your lender may give you the option of refinancing based on its new value, giving you access to the equity you’ve built up through your mortgage repayments.
It’s important to note that because you are digging into your equity, you will have to pay that back at some stage, plus interest.
Cross collateralisation is where you use the equity you’ve built up in one property to buy another property. This is a very risky practice because the property you currently own and the property you’re buying both become security on the loan. If you fail to make the mortgage repayments, you could stand to lose both properties. It’s important to note you can only cross collateralise with one lender.
If your mortgage has a redraw facility you can access the equity you’ve built up by drawing down on it.
A redraw facility allows borrowers to make extra repayments on their mortgage, and then withdraw (or ‘draw down’) on them later on. Any extra repayments you make that are accumulated in the redraw facility are separate from your regular mortgage repayments, which is how they are available to withdraw.
A reverse mortgage is actually a variation of home equity loan. This, however, is usually reserved for retirees who own 100% of their properties.
A reverse mortgage allows you release part of your property’s value, either as a lump sum or regular stream of income. Lenders do not often require monthly repayments for this type of mortgage, but they charge interest and expect you repay the full amount if you sell the property, or in the case of retirees, if they move into aged care or pass away.
How much equity can you borrow?
Different lenders have different policies on how much they are willing to lend for home equity loans. It also does not necessarily mean that just because you have equity built up, you will be able to access the full amount.
Most lenders want you to retain at least 20% of the property’s value as a form of security on your mortgage. If you want to use your home’s equity but still have a balance of more than 80% of the property’s value, you may also be required to pay for Lenders Mortgage Insurance (LMI).
You can calculate the amount of you are allowed to borrow using this formula:
(Home’s Value x 80%) – Mortgage Balance = Accessible Equity
For example, if your home is worth $600,000 and the remaining balance on your mortgage is $250,000, then the equity you have in your loan is $350,000. To determine the amount of accessible equity, you need to find the difference between 80% of your home's value and your outstanding balance.
($600,000 x 0.8) – $250,000 = $230,0000
In this example, you may be able to access $230,000 of your $350,000 equity. Borrowing more than this amount will require you to pay for LMI.
How can you build equity in your home?
There are several ways you can build equity in your property, but the simplest and most popular means are reducing the amount you owe your lender and increasing the property value.
Paying off your mortgage
Every time you make a repayment, the equity in your home increases. You can also accumulate equity faster by making extra repayments on your home loan principal whenever you can afford it.
The current market trends also have a huge impact on how much equity your property builds up. If house prices continue to soar, it is very likely that your home may be worth more than when you first took out your mortgage.
Adding value to your home
Making strategic renovations increases the value of your property, which in turn raises its equity. You may even be able to tap into this equity to fund your renovations using a home loan.
What can a home equity loan be used for?
A home equity loan can be used for a variety of purposes which include the following:
If you have enough equity in your property, you can consolidate all your debts into a single large repayment instead of paying it off in several smaller chunks. This allows you to save on interest rates and simplify your finances.
You can use the loan amount to fund home improvement projects, which can help increase the value of your property.
A home equity loan can provide a means to further grow your wealth by using the money as a deposit for an investment property. You can also use it to invest in shares, secure bonds, or start a business.
Lifestyle expenses and other big purchases
You can also access equity in your home to fund a range of personal expenses, including a child’s education, new car, wedding, or a holiday.
Is a home equity loan the right option for you?
Just like any other options currently in the market, a home equity loan caters to people with specific financing needs and circumstances. A home loan equity loan may be the right option for you if:
- You want to access additional funds without having to sell your property
- You have already built up a significant amount of equity in your loan
- You are planning to renovate but do not want to take personal loans or use your credit cards
- You want to start building up your investment portfolio without having to apply for a separate mortgage
What are the downsides to getting a home equity loan?
A home equity loan allows for relatively easy access to funds, and it may sometimes be tempting to use the money in an irresponsible manner. Bear in mind that a certain level of financial discipline is needed for you to reap the full benefits of accessing your home’s equity.
You must remember that taking out a home equity loan also means that you are increasing your debt, which has a corresponding impact on your repayments. You also need to pay for the different fees and charges associated with taking out the loan. Accessing your equity unnecessarily may bury you further into debt, so you need to be wise in deciding when to do so.
Getting a home equity loan also has its share of pitfalls. For one, it could potentially put you in a worse financial situation if the funds you used did not grow in value. For instance, you might end up overcapitalising when you renovate your home. This happens when the costs exceed the value that your property gets from the renovation. It can also happen when your ventures to property investing are unsuccessful.
Speak to a mortgage broker to know your options
If you are unsure whether a home equity loan is the right option for you, you can always reach out to a mortgage broker to get an expert opinion.
Mortgage brokers can help determine whether you have enough equity saved up in your property to even qualify for this type of loan. They can advise you if it would be a wise move, given your financial circumstances, to borrow against the equity of your home.
Furthermore, they can provide you with other options that are more fit to the purpose that you in mind. Will refinancing your mortgage be a better option? Or should you just take out a personal loan? These are the questions mortgage brokers can help give the answer to.
Collections: Home Loans