What is home equity?
Your home equity is the stake in your property you own outright. For example, if you owe $400,000 on your home loan and your property is valued at $1,000,000, you have $600,000 of equity.
What is ‘negative’ equity?
Negative equity means you owe more on your mortgage than your property is worth. Say you took out a $950,000 loan to buy a house for $1,000,000, but the market turned and the property is now only worth $900,000—your equity would be -$50,000.
In such cases, if you’re struggling to meet your repayments, selling the property may not see you out of debt.
Also, if you default on your loan, your lender may not be able to recoup all its costs by repossessing and reselling your home.
Loans with higher loan to value ratios (LVR) can have a higher risk of negative equity. This is part of the reason lenders mortgage insurance (LMI) is only charged when a borrower’s LVR exceeds 80%.
What is a home equity loan?
A home equity loan allows you to borrow more money against the equity you’ve built up. There are a number of different ways you could do this:
- Refinancing or topping up your existing loan to borrow more, thereby unlocking equity as cash.
- Taking out a line of credit loan may allow you to withdraw funds up to an approved limit, based on the equity you have in your home, and only pay interest on what you withdraw.
- If you’ve got funds available in your redraw facility, taking this money out can work like a home equity loan.
How do you build equity in your home?
There are two ways the equity in your property can grow:
- You pay off more of your loan. Paying down the principal balance of your home loan can increase your equity. Anything you pay on top of your minimum repayments can speed up this process.
- Your property goes up in value. The other side of this equation is, if your property is worth more, your equity will have increased. If your property declines in value though, your equity will decrease.
Should you get a home equity loan?
Benefits of home equity loan
- Could help you add to your property’s value
You could use your home equity loan to renovate your property, potentially adding to its value. - Potentially lower interest rates
Rates are generally lower on home loans compared to other finance options. If you’re looking to buy a car, for example, it could be cheaper to borrow against your home equity rather than take out a car loan. However, if you don’t also up your repayments you could end up accruing interest on the extra amount you borrow for your entire home loan term. - Can be used to buy income-producing assets
You could also use a home equity loan as a deposit for a second property or to invest in other assets, like shares. Be careful though if you’re leveraging your home to buy volatile assets, because this can be very risky.
Drawbacks of home equity loan
- Costs involved
You could face refinancing fees, even if you’re just topping up your loan with your existing lender. You might also need to pay for a new valuation of your property. - Greater interest burden
Borrowing against your equity means taking on additional debt, which can mean paying more interest. If you don’t up your loan repayments after borrowing against your equity, you could be accruing interest on the extra balance for years. - Potential for mortgage stress
Borrowing more money against your home equity can leave you with larger repayments, which can weigh on your finances. And if you default on your repayments, you could risk losing your home.
What is usable equity?
‘Usable equity’ is the portion of your equity your lender will allow you to borrow against with a home equity loan—commonly 80% of the property value.
Say you’ve got $500,000 in equity and your property is worth $1,000,000. Your usable equity is calculated using 80% of the value ($800,000), which means your usable equity is only $300,000.
Is a reverse mortgage a home equity loan?
A reverse mortgage lets you borrow against your equity. Unlike other financial products though, you don't make regular repayments when you take out a reverse mortgage, just pay the loan back when you sell the property.
Reverse mortgages are generally reserved for older homeowners, typically those aged 60 and above. Often, the older you are, the more you can borrow. Reverse mortgages are usually offered by specialist lenders. Although, if you qualify for a pension, you might be able to access the government’s Home Equity Access Scheme, which may offer lower rates.
Do you need to pay LMI on a home equity loan?
Lenders mortgage insurance is generally applied if your LVR is above 80%. Unless an exemption applies (you’re borrowing with support from the 5% Deposit Scheme, for example), if you’re refinancing against your existing equity and, as a result, your LVR is above that threshold, you might have to pay LMI (even if you’ve already paid it).
However, many lenders calculate your usable equity using 80% of the property value, which means you may not be able to borrow a large enough sum to trigger LMI.
