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 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 typically increases as you pay off your home loan and as the value of your home increases. Based on the scenario above, if your property’s value increases from $450,000 to $500,000, you’ve now got $150,000 of equity in your home.
On the flip side, if the value of your home ever drops, your home equity will also suffer. So, 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.
How do I work out my property value?
If you’re just curious and don’t need an accurate figure, you can work out an approximate value by looking at other comparable homes on the market and recent sales prices.
If you’re looking for something a bit more solid, you can have your property valued by a valuer. Typically this will involve making a time for the valuer to walk through and assess your property, and depending on their timelines, they’ll come back with a valuation within a few days.
Besides the satisfaction of knowing how much you’ve paid off, you can put your equity to work. Here’s how:
If you’re looking to borrow against your home equity (see some options below) you will need to calculate how much of your equity you can actually access. Lenders set limits on this based on your Loan to Value Ratio (LVR), your ability to service a larger loan, and what you may be using it for.
For example, let’s say your lender allows you to borrow up to 90% of your property’s value (90% LVR), and your home is worth $500k. If your current loan amount is $400k, you have $100k in equity. But you can only access up to $50k to ensure you don’t borrow more than 90% of the $500k value. Your lender will also need to assess whether you can service the additional $50k.
A deposit for an investment property
You’ve saved up for a home loan deposit before, so you know it can take a long time to save up the standard deposit amount of 20% regardless of the property value. Coupled with other financial obligations that come with home ownership, this can make that goal seem harder to reach. Using your equity as a deposit can help you get an investment property without having to spend the same amount of time saving while also making 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 dip into your savings.
Purchasing a car
Car loans can come with some pretty expensive interest rates and buying a car outright using your savings might not be an option. Using the equity in your home frees up money for your purchase now and gives you the benefit of a lower interest rate.
Consolidating your debt
Personal loans, car loans, and credit cards all have notoriously high-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?).
Keep in mind that whilst home loan rates are generally lower than other forms of credit (e.g. personal loans or other credit lines), your loan term is typically much longer which means you could pay more interest overall over the life of your loan. We recommend seeking out professional financial advice before you make a decision.
To access the equity in your home you’ll have 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 sure you are only borrowing 80% of your property’s value (some lenders allow up to 90% with LMI) so you’ll need to account for this when deciding how much equity you want to use.
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 principal and interest 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. Interest only rates apply over a fixed period (typically between 1-5 years) which means you aren’t paying off the loan component and not increasing equity. On the flip side, P&I repayments mean you are paying both the interest that has accrued AND some of the principal amount of your loan. This means as you make more repayments you are steadily paying down your loan amount too.
Pay more than your 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. If your loan has a redraw facility, you can always redraw these additional funds – remember to allow 1-2 business days for the transfer to be made.
Renovate to add value to your home
If you have the resources (time, money and skills), renovating could be 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.
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 (especially the repayments), so 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 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.