If you’re a homeowner who’s thinking about buying an investment property to increase your wealth, or you need cash for other reasons, you may be sitting on a large, untapped source of available funds — also known as home equity.
What is home equity?
Home equity is the part of your property you own outright — the property’s value minus the amount still owing.
In other words, if your lender values your home at $800,000 and you still owe $300,000 on your mortgage, your home equity is $500,000. Put simply, subtracting the loan amount from the value gives you your home equity — the amount of the property that you own outright. This is also reflected in your loan-to-value ratio (LVR).
Home equity is important for a number of reasons, not the least of which is that it gives you and your bank a clear understanding of how that property contributes to your net worth or asset value.
More importantly, home equity provides you with access to funds you can unlock and use for a range of purposes, such as investment property, renovations, holidays and education fees. You can also use it for debt refinancing at a much lower interest rate than if you were to take out a personal loan or acquire another credit card.
How to use the equity in your home
Once you’ve decided to access your home equity, you’ll need to arrange a valuation to find out exactly how much equity you have. Your financial institution should offer you a free valuation, given it’s usually in their best interests to provide you with a loan based on that equity.
Generally speaking, you can access up to 80% of your home’s value, but unless you’re undertaking major renovations or you have no other way of funding what you need the money for, you should be looking to use far less than that.
The amount the bank is willing to release will also depend on your ability to pay it back, just like your initial mortgage. This means that your lender will want to look at your current employment situation and your monthly expenses before they increase your debt.
Types of home equity loans
There are three types of home equity loans that you can tailor to your individual needs:
Each has its own pros and cons, so it’s always best to consult a financial adviser — preferably one recommended by your lender — to choose the home equity loan that’s best for you.
A line of credit
A line of credit lets you draw down part of your home equity to use as you need. If, for example, you have a line of credit for $100,000, you may want to spend $30,000 on a new car and a few months later, use the remainder to take a holiday or refinance your debt. The benefit of a line of credit arrangement is that you only pay interest on the portion of the credit that you draw down, not the full line of credit amount. The drawback to a line of credit is that you generally require a high level of home equity before your bank will consider approving it.
A renovation loan
A renovation loan lets you draw on your equity to make home improvements, which has the twofold benefit of making your property more liveable while increasing its value and, consequently, your home equity.
Home loan top-up
The third home equity loan option is a home loan top-up. Like other financial instruments, such as a reverse mortgage, you can use a home loan top-up for various non-property-related expenses. These may include holidays, cars, HECS-HELP student debt payments, debt consolidation for credit cards and personal loans, or just about anything the bank deems worthy.
Home loan top-ups provide a solid alternative to taking out a loan at a higher interest for any of the above reasons. However, you should always be careful about how much you want to tack back onto your mortgage, how much you can afford to repay, and if you wish to eat into your hard-earned equity for something you might not even need.
A loan-to-value ratio, or LVR, compares the home loan amount to the appraised value of a home. LVR ratios are evaluated when buying or selling a home, renewing or refinancing a mortgage, and when getting a home equity loan.
How you save for a deposit and how long it takes you will be a good indicator not only of how well you manage your finances but how much you can realistically afford in regular mortgage repayments.