Home Equity 101
Want to maximize your existing property? Australians have the option to use home equity to purchase an investment property and to fund small businesses.
Stats note that home equity withdrawals amounted to roughly 4.65% of the country’s GDP. This resource can be used for numerous purposes, from injecting capital to investments to spending on general household consumption needs.
Many homeowners are considering using home equity, especially with the rising home prices in recent years. When you have raised enough equity and want to access it, read on to find out how a home equity works, when it is most useful, and how to maximize the value of your existing home.
What is home equity?
Home equity represents the portion of your property that you truly own, calculated by subtracting the outstanding mortgage balance from the property’s current market value. As you pay off your mortgage or as property values increase, your home equity grows. It serves as collateral for home equity loans, allowing homeowners to tap into this value for financial needs.
Home equity is a mortgage holder’s portion of the home. Take note, there are still repayments being made on the home loan. Home equity represents the difference between the current value of your property and how much is owed on the mortgage.
For example, your first home is valued at $400,000. To avoid paying lenders mortgage insurance (LMI), you deposit 20% – $80,000. The mortgage is $320,000 to cover the difference. Before any repayments on the mortgage, your home equity is at $80,000.
Five years into the monthly repayments, you have already chipped $70,000 from the home loan principal amount. And at this time, the value of your home increased to $450,000.
So at this point, your home equity is calculated: $450,000 home value – $250,000 = $200,000.
You can use our Home Equity Calculator here (link) to get an estimate of how much your home equity is right now.
Does equity help my borrowing power?
Yes, because you can access equity to support your next loan.
Building enough equity means you may not be required to put up a deposit if you’re purchasing another home. That equity becomes a deposit and therefore, is your leverage to secure a new loan or to refinance your existing loan.
Equity basically helps you increase borrowing power without selling the property.
What can I use my home equity for?
Buying an investment property – Some homeowners leverage their home equity to seize investment opportunities. This can involve purchasing additional properties for rental income or investing in stocks, businesses, or other ventures. Lenders generally allow clients to borrow up to 80% of the property value.
Home renovations – Many homeowners use their home equity to fund renovations or upgrades to their property. This can include a kitchen or bathroom remodel, adding an extension, or enhancing the overall aesthetics and functionality of the home. Investing in home improvements can enhance your living experience and potentially increase the property’s value.
Investing in other forms of assets – Some people also decide to use the equity in their home to grow their wealth further by investing in the share market or starting a business. Investing in assets like shares or exchange-traded funds (ETFs) enables you to diversify your money and not tie it to one big asset.
Consolidate debt – Home equity loans can be used to consolidate high-interest debts, such as credit card balances or personal loans. By combining multiple debts into a single home equity loan, you may benefit from a lower interest rate and have a structured repayment plan, simplifying your financial management and potentially reducing interest costs.
Education expenses – Home equity can be tapped into to finance higher education expenses for yourself or your family. Whether it’s funding college tuition, vocational training, or other educational pursuits, using home equity can provide funds to invest in knowledge and career development.
Travel and lifestyle – Home equity can be used to finance personal aspirations and experiences, such as travel adventures, a dream vacation, or fulfilling bucket list items. Using home equity for lifestyle purposes should be carefully considered to ensure it aligns with your overall financial goals and priorities.
What are the pros and cons of accessing equity?
So is it really worth tapping into your home equity? Let’s talk about the pros and cons:
Pros to home equity loan
Access to funds. Utilizing your home equity gives you access to a substantial amount of funds that can be used for various purposes, such as home improvements, debt consolidation, or investment opportunities. This can provide financial flexibility and the ability to achieve your goals without resorting to higher interest borrowing options.
Lower interest rates. Home equity loans often offer lower interest rates compared to other forms of borrowing, such as personal loans or credit cards. By using your home equity, you may benefit from reduced interest costs, potentially saving you money over the loan term.
Potential tax incentives. Depending on your location and the purpose of the loan, accessing your home equity may offer potential tax advantages. In some cases, the interest paid on home equity loans used for investment purposes may be tax-deductible. It’s important to consult with a tax professional to understand the specific tax implications in your jurisdiction.
Debt simplification. If you have multiple debts with high-interest rates, accessing your home equity can enable you to consolidate those debts into a single loan with a potentially lower interest rate. This simplifies your financial management, as you only need to make one payment each month.
Cons to accessing home equity
Risk to homeownership. When accessing your home equity, you are using your property as collateral. If you default on the loan, you are risking foreclosure and ultimately losing your home. It’s crucial to carefully consider your repayment ability and financial stability before utilizing your home equity to mitigate this risk.
Increased debt burden. By accessing your home equity, you are increasing your overall debt obligations. This means you will have additional loan repayments to manage on top of your existing mortgage. It’s important to ensure that you can comfortably afford the increased debt and consider the impact on your monthly budget.
Potential market fluctuations. If property values decline, it can affect the amount of equity available or lead to negative equity. Negative equity occurs when the outstanding loan balance exceeds the property value. This can limit your future borrowing capacity and pose challenges if you need to sell the property in the future.
Costs and fees. Accessing your home equity may involve various costs and fees, such as application fees, appraisal fees, legal fees, and potentially mortgage insurance premiums. It’s important to consider these expenses when evaluating the financial viability of accessing your home equity.
Long-Term financial impact. Using your home equity for non-essential purposes or short-term gratification may have long-term financial implications. It’s important to consider the impact on your overall financial plan, retirement goals, and future financial security before accessing your home equity.
What is negative equity?
Depending on the housing market, owning a property doesn’t always mean that you gain equity in the bank.
Negative equity, also known as an underwater mortgage or being “upside down” on a loan, occurs when the outstanding balance on a mortgage or loan exceeds the current market value of your property.
In simple terms, it means that you owe more on your mortgage than what your property is worth.
Negative equity typically arises when property values decline or when a client takes on a high loan-to-value ratio (LVR) loan, meaning they borrowed a significant portion of the property’s value.
It can also occur if a property has undergone significant depreciation due to factors like economic downturns, housing market fluctuations, or local market conditions.
Here’s an example to illustrate negative equity: Let’s say you purchased a property for $300,000, with a mortgage of $250,000. However, due to unfavorable market conditions or a decline in property values, the current market value of the property has dropped to $200,000. In this scenario, your loan balance of
$250,000 exceeds the property’s market value, resulting in negative equity of $50,000.
How to access equity from your home
If you’ve done proper consultations with mortgage professionals and decided on tapping on the equity, here are different ways to do so:
Refinancing
Refinancing your existing mortgage involves switching to a new loan, often with better terms, features, or a larger loan amount. Refinancing lets you get a portion of the home loan equity as cash.
Banks first revalue the property before refinancing the mortgage. If it has risen in value, the new value will have a higher principal balance, and you’ll receive the difference between the new loan and the old loan balance as cash proceeds. Of course, digging into your home equity means that you’ll end up paying it back with interest later.
Line of Credit
Like a credit card, a home equity line of credit provides you with a predetermined credit limit. You only pay interest on the amount borrowed, and as you repay the borrowed amount, it becomes available for future use. Line of credit could be useful for ongoing projects with variable costs, but you have to be mindful of repayments and possible interest rate hikes.
Cross Collateralization
Cross collateralization involves using the equity in one property to secure financing for another property. It allows you to leverage the equity in one or multiple properties to borrow a larger sum or access financing that may not be available based solely on the equity in a single property.
This feature can be useful for property investors who want to maximize their borrowing capacity. But it is a high-risk strategy, as defaulting on one property may affect the others that are cross-collateralized – you could end up losing not just one but multiple properties.
Reverse Mortgage
A reverse mortgage is a financial product specifically designed for homeowners aged 60 or older. It allows them to access their home equity as cash while retaining ownership of the property – basically borrowing back the money paid towards owning the home.
With a reverse mortgage, the lender provides regular payments or a lump sum based on the equity in the home, and the amount accessible is capped based on your age.
You’re not required to pay back the reverse mortgage while living in the home; it is repaid when the homeowner sells the property, moves out, or passes away.
Reverse mortgages can provide financial flexibility for seniors who want to supplement their retirement income or cover specific expenses. However, it’s essential to understand the terms, fees, and potential impact on inheritance or other financial plans before considering this loan.
Let us help with your home equity loan
Deciding on accessing home equity entails a careful evaluation of your financial needs, repayment ability, and its considerations.
Let our experienced mortgage brokers help you navigate the options to minimize your risk. By understanding what you can do with home equity, you can choose to continue building it or go ahead and utilize the most suitable method of accessing it.
