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.
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?
Home equity is the difference between the value of your property and the amount you owe in your mortgage. It is the portion of your home that you actually own. Banks and other lenders will often allow you to use this equity as security so you can borrow money through a home equity loan.
Home equity loans come in two main types. These are:
1. Lump sum
This works similar to your mortgage, where you borrow an approved amount – called a lump sum – and make the necessary repayments – including interest – over a certain period.
2. Line of credit
This lets you a borrow and repay, usually a smaller amount, when a need arises. Using a line of credit also gives you the flexibility to reborrow as long as you do not exceed the maximum limit of your available equity.
Reverse mortgage is another type of home equity loan, but this 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 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 how the amount you owe your lender and increasing your home’s value.
1. 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, just like what is happening now, it is very likely that your home is worth more than when you first took out your mortgage.
2. 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.
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 the 80%, or 0.8, of your home's value and your outstanding balance.
($600,000 x 0.8) – $250,000 = $230,0000
In this sample, you may be able to access $230,000 of your $350,000 equity. Borrowing more than this amount will require to pay for LMI.
What can a home equity loan be used for?
A home equity loan can be used for a variety of purposes. These include:
If you have enough equity on your property, you can consolidate all your debt 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.
You can also access equity in your home to fund a range of personal expenses, including a child’s education, new car, wedding, and holiday vacation.
What are the benefits of taking out a home equity loan?
Taking out a home equity loan allows you access funds without having to sell your property. Interest rates are also generally lower compared to other types of loans – personal loans or credit cards for example – and it is often easier to get an approval. In addition, depending on how you use the loan amount, you may be able to build wealth via sound investments or increasing your property’s value.
What are the disadvantages of taking out a home equity loan?
Because taking out a home equity loan allows a relatively easy access to funds, 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 can bury your further into debt, so you need to be wise in deciding when to do so.