What is a home equity loan?

ALASDAIR DUNCAN
What is an equity loan and how does it work? Here are some ways you may be able to use the value of your home to borrow money.

If you own a home and you need to access funds for a particular purpose, be it to conduct a home renovation, buy an investment property, or even consolidate debts, then an equity loan might be an option for you.

What is home equity?

Home equity is the difference between the value of your home, and how much you still have left to pay on your mortgage. Say, for example, you have a home with a market value of $600,000 and a mortgage with $300,000 left to pay. This would mean that you have $300,000 in home equity.

What is a home equity loan?

A home equity loan is a loan that allows you to borrow money against the equity you have in your property. There are a number of different ways you could do this:

  • A line of credit loan, which allows you to withdraw funds up to an approved limit based on the equity you have in your home, and only pay interest on the funds you have withdrawn.
  • If you have a variable rate mortgage, then you may be able to take advantage of a redraw facility, which will let you access funds from any additional repayments you have made on your home loan, or an offset account.
  • Refinance your mortgage, which might allow you to restructure your home loan and take advantage of the equity you have.

How can you use the equity in your property?

You may be able to leverage the equity in your home for any number of purposes, depending on the lender, but some reasons might include:

  • Investing in property: You may be able to use your home equity to help finance the deposit on a new home, and you may choose to use this or your current home as an investment property, which could generate rental returns or other benefits
  • Undertaking home renovations: If you have a major home renovation planned, such as a new kitchen or bathroom, you might be able to use the equity you have in your home to fund it, and increase the value of your home at the same time
  • Debt consolidation: If you are in the process of repaying debts, you may be able to combine these into an equity loan, which could potentially have a lower interest rate than other forms of credit. (It could be a wise idea to seek independent professional financial advice.)

How can you build equity in your home?

Building equity is about increasing the gap between what you owe and the value of your home. So, there are two main ways that you can build equity in your home:

Reduce your debt

Paying down your mortgage lowers the “owe” side of the equity equation. There are a few factors to consider in this scenario. Whether or not you are able to pay off your home loan faster may depend on the type of loan and its terms and conditions. For example, if you have a variable rate home loan, then your lender will typically allow you to make extra repayments without a penalty. The same is generally not true of fixed rate home loans. Also, it could be wise to keep in mind that even if you pay off more of your loan, you might not end up with more equity if the value of your home was to decrease.

Increase the value of your home

Generally speaking, the longer you have owned your home, the more its value will likely have grown (depending on a number of factors). This could equal more equity. However, if you don’t want to wait, you might like to explore some home improvements. According to real estate agency Raine and Horne, undertaking certain renovations could potentially boost the value of your home, as long as you budget carefully.

If you are considering renovations, it is important to keep in mind how much value they might actually add to your property, and how much the process will cost. A property valuer may be able to advise you on how much value a proposed renovation project might actually add to your property, and whether it is worth you making the investment.

What are the potential drawbacks of equity loans?

Taking on an equity loan means taking on additional debt, so it is a wise idea to carefully consider whether doing so will ultimately assist you in growing your wealth. Potential drawbacks can include the fact that approval is not guaranteed and that you will be taking on additional debt as well as financial risk due to unforeseen circumstances.

Approval is not guaranteed

It is worth keeping in mind that any application you make for an equity loan might not necessarily be approved. Your lender will take into consideration your financial circumstances and any assets and debts you might have before approving you, and you may be unsuccessful.

If you wish to use the equity in your home to access funds, but your primary lender will not approve your application, you may instead take out a second mortgage with another lender, but bear in mind that the lending criteria for these can be stringent, and they can come with high fees and charges. Any loan application decisions are also likely to be recorded on your credit file, which could impact your credit score, a measure that some lenders use to assess loan applications.

Additional debt

Taking out an equity loan means that you are taking on additional debt that you will need to pay back. Generally speaking and depending on how the loan is structured, this will mean that you will have to pay your existing mortgage (if you have one), as well as any equity loan repayments.

Unforeseen circumstances

Taking out an equity loan also means you could be taking on more financial risk. For example, if you are using the funds to buy an investment property, and your tenants fail to pay the rent on time, there’s a risk that you could default on your loan if you cannot cover the repayments without that extra income. That could impact your credit score, and lead to other implications, such as foreclosure. If you used an equity loan to renovate your home and, for example, the renovations did not deliver the expected lift in value, you could face a situation where the loans you have over the home are worth more than the home itself (called negative equity).

If you are in the market for a home loan or seeking to review your current arrangements, you can compare over 5,000 mortgages from more than 80 lenders across Australia on Canstar’s database, to find one that might be suitable to your needs.

 

Cover image source: MIzkit/Shutterstock.com


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