Home loans explained
What does home equity mean and how does it work?
6 min read
If you own a home chances are you've already built up a bit of equity. But what is home equity, and how can you use it?
Home equity is just a fancy name for the difference between your property’s market value (what it’s worth) and what you currently owe on your home loan. In other words, if your home is currently worth $450,000 and your home loan balance is $350,000, then you have $100,000 of equity in your home.
Your equity increases as you pay off your home loan and as the value of your home increases. For example, if your property’s value increases from $450,000 to $500,000, you’ve now got $150,000 of equity in your home.
But this also means that if the value of your home ever drops, your home equity will also suffer. So on the flip side, if the market isn’t doing so well and that $450,000 home you own (with $100,000 of equity) is now only worth $400,000, you now only have $50,000 of equity in your home, bummer.
What this means is if you want to know how much equity you have in your home you’ll need to have your property officially valued. If you’re just curious and a rough estimate will do, you can get an approximate value for your property by looking at other comparable homes on the market to see what they are selling for.
There are quite a few things that you can use your home equity for, and because home loan rates are generally lower than other forms of credit, it can be a cheaper alternative to taking out a personal loan or other credit lines.
You can use your equity for things like
· A deposit for an investment property
· Financing a renovation on your current property
· Making a large purchase (like a car)
· Consolidating the other debt you have
A deposit for an investment property
Saving up for a home loan deposit can be difficult, especially if you have other financial obligations that need to be paid as well. Using your equity as a deposit can help you get an investment property without having to spend time saving while also paying your home loan repayments.
Financing a renovation on your current property
Renovating your current property can help to increase your property’s value (and further increase your home equity). Using your current equity to pay for your renovation is a great way to improve your home without needing to use your savings.
Purchasing a car
Car loans can come with some pretty expensive interest rates and saving the money to purchase a car takes time. Using the equity in your home frees up money for your purchase now and gives you the benefit of a lower interest rate.
Consolidating the other debt you have
Personal loans, car loans, and credit cards all have notoriously bad interest rates and fees associated with them. Because of this having multiple credit lines means you could be paying more interest and fees than you really need to. Using your home equity to pay out these debts bringing it all under the one loan means you are only paying interest (and fees if there are any) on one line of credit at a lower interest rate. This means you’ll end up paying less interest over time (and who doesn’t want that?).
To access the equity in your home you’ll to do what’s known as a cash-out refinance. To do this you’ll need to increase your loan amount to account for the equity you want to use or ‘liquidate’. Typically your lender will want to make you are only borrowing 80% (in some cases 90%) of your property’s value so you’ll need to account for this when deciding how much equity you want to use.
So, going back to our earlier figures…
If the market was kind and your property has increased in value to $500,000, you’ll have $150,000 of equity in your home. And if you wanted to use some of that equity you could refinance your home loan (currently $350,000) for $400,000 (80% of $500,000), giving you an extra $50,000 in your pocket.
Aside from the market value of your home increasing, there are a few things you can do to help build up more equity in your home.
Make a bigger deposit
The very first thing you can do to ensure you have some equity in your home is to make a large deposit. Generally lenders will want you to have a 20% deposit (10% with Lenders’ Mortgage Insurance), but if you can save up more than 20% you won’t need to borrow the full 80% to purchase your home. Meaning you’ll have more equity in your home right from the start.
Make principal and interest repayments
When applying for a home loan you can choose between interest only (IO) or principal and interest (P&I) repayments. Interest only repayments mean you are only paying the interest amount that you’ve accrued each month, and your principal loan amount remains the same. This means you aren’t increasing your equity at all. P&I repayments mean you are paying both the interest that has accrued AND some of the principal amount of your loan. Which means as you make more repayments you are increasing your equity.
Pay more than you minimum amount
Making additional repayments to your home loan will lower your loan amount quicker and increase your equity. Although, some home loans (fixed rate loans in particular) have a limit on how much extra you can put into your home loan each year, so be mindful of this when making your payments.
Do a cash-in refinance
A cash-in refinance is pretty much the opposite of a cash-out refinance (the refinance you’d do to liquidate your equity). To do a cash-in refinance you refinance your loan for less than your current loan amount, and contribute a lump sum of money to close your old loan. Refinancing does have some cost to it though, so you need to account for this as well.
Renovate to add value to your home
If you have the cash for it, renovating is a great way to add value to your home and increase your equity. Adding an extension, renovating an old kitchen, or landscaping your garden can increase the curb appeal of your home and bump up its value. Plus you get to enjoy a brand new kitchen, it’s win-win!
While it can be handy to use home equity instead of digging into your savings or taking out another loan, there are some downsides that you should be mindful of.
Firstly when you liquidate your equity you are increasing the amount of debt that you have (unless you’re doing so to consolidate your debt). You should make sure that you are comfortable and able to handle this increased debt and get some financial advice if you need it.
And as we’ve already mentioned, there are some costs involved in refinancing your home loan to access your equity. When refinancing your home loan, it’s important to account for the government costs and other fees that lenders may charge. These can quickly add up and you may find that you don’t end up with as much extra money as you thought you would.
With any big financial decision it’s best to consider what your needs are, and seek financial advice so you can be sure you get the outcome that’s right for you.