What is a home equity loan?
What is a home equity loan?
Katy Holliday - 7 Sep, 2020
An opportunity to build your investment portfolio, consolidate debts or fund renovations, a home equity loan is one-way property owners can reach their financial goals without having to sell their home to take advantage of the equity.
If you’re a homeowner and have been repaying your loan steadily, it’s likely you’ve built up some usable equity. Whether you need a deposit for a new property or cash for home maintenance projects, a home equity loan may be for you.
Let’s answer the question of “what is a home equity loan”, explore how it works and what the requirements are when applying for this type of loan.
What is home equity?
Home equity is the difference between what your home is worth in the current property market and the balance still owing on your home loan. If you’ve been paying off your mortgage for a number of years, you’ve probably accrued a decent amount of equity in your home that you may be able to access.
In certain cases, you can borrow against the equity in your home to help you achieve your financial goals. As you pay down your home loan, and as long as your property value continues to increase, your home equity will grow.
What is a home equity loan?
A home equity loan is a lump sum loan where a homeowner borrows against the equity in their home to finance major purchases, such as investing in property, switching over loans, or other lifestyle decisions.
It’s an inexpensive source of credit available to property owners that can be used responsibly in situations where there is not enough cash savings accrued to finance your needs. In order to access the funds, you may need to refinance your existing home loan.
Two of the types of home equity loans available are:
- Variable-rate mortgages with a redraw facility
- 100% offset home loans.
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How does a home equity loan work?
The basis of a home equity loan is very similar to a standard mortgage and generally needs to be repaid over a fixed period, with a fixed rate. Sometimes there is the option for a variable rate.
You will need to meet the minimum interest-only monthly payments, with the option of principal and interest repayments. A home equity loan usually comes with flexible terms, which allow you to make unrestricted additional payments.
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When establishing your home equity, it’s important to understand that not all of it will be “usable equity”. Most lenders will let you borrow a maximum of 80% of the property’s value minus the remaining loan balance, without having to pay Lender’s Mortgage Insurance (LMI).
There are lenders who may release up to 95% of your equity, but that’s conditional to you paying the LMI premium and your ability to service the loan. Even if you’ve paid LMI on your original property loan, you will still need to pay it again. This can make your home loan much more costly when taking into account interest rates and monthly payments.
Some lenders operate a cash out policy, which means the lump sum you can release is restricted to between $10,000 and $50,000. It’s best to talk to an experienced broker to find out which lenders would work best for you.
What are the requirements for a home equity loan?
To qualify for a home equity loan you should have at least 20% equity in your home. Not only does the equity amount determine how much you can borrow, but it can also protect you from mortgage stress. You may need to get a property valuation to find out how much equity is in your home and calculate the appropriate loan-to-value ratio (LVR).
You will usually need to prove you can service your new loan by having:
- A strong credit report: Which will also help you get lower interest rates
- Sufficient income: To manage the repayments with a better debt-to-income ratio
- A solid repayment history: Proof that you are a reliable borrower and pay bills on time will give lenders more confidence in you.
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What is an example of a home equity loan?
The main type of home equity loans you can apply for is a lump sum.
With the lump sum option, you can refinance to borrow a lump sum from the lender and commit to newly increased repayments over time. You can use this equity for cash out on future investments or deposits for additional properties.
Some lenders will allow you to borrow 100% of the investment property price plus costs to purchase an additional property and build your portfolio.
What can a home equity loan be used for?
One of the main reasons people may opt to use their equity, rather than using credit cards or personal loans, is that home loan interest rates are often substantially lower. It means that when it comes to purchasing larger assets like an investment property or consolidating debts, you could potentially save a lot of money on monthly payments.
If your home is worth more than when you bought it and you’ve paid down some or all of the balance on your loan amount, you may be able to access your equity for:
- Home renovations: If you’re making improvements to raise the value of your home or completing maintenance projects to make your home more liveable for you, you can finance these changes with a home equity loan.
- Purchasing property: You can leverage your home equity as a deposit for an investment property or your next home, and expand your property portfolio.
- Buying shares: Home equity can be used to invest in shares or managed funds.
- Debt consolidation: With lower interest rates than credit cards, home equity loans are a good strategy for eliminating high-interest debt.
- Other large purchases: Home equity can also finance other lifestyle decisions, such as travel, a new car or starting up a business.
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Are there any disadvantages to a home equity loan?
One of the main disadvantages homeowners may find with home equity loans is that there is a substantial increase in debt size that comes with borrowing against the equity in a property.
The property owner will owe the bank a lot more money and the monthly payments will be higher, oftentimes with higher interest rates than traditional variable rate loans. This can sometimes take a longer period of time to pay back to the bank.
Another consideration when applying for a home equity loan is the associated costs and fees. When using the equity in your home, opening the new home loan and finalising your existing home loan can attract fees. In many cases, it is still worth borrowing equity.
Is a home equity loan suitable for me?
For each homeowner, the right loan type will be different. If the person applying for the home equity loan is responsible and disciplined with their money and has a strong credit history along with a steady income, then this loan type can be a rewarding option.
As part of the process of applying for the home equity loan, the existing mortgage has to be refinanced. Having a plan on how to repay the equity loan and ensuring it is used wisely can be financially advantageous to the homeowner.
How do you prove the purpose of your home equity loan?
When applying for a home equity loan, some lenders require you to prove the purpose of your loan. This can also be dependent on the loan amount you require for your purpose.
One example where you need to provide proof is if you are planning on making renovations to your existing home. In this case, you would need to supply a copy of quotes or the building contract from your contractors.
Here are some other cases where you may need to provide evidence to support the purpose of your home equity loan:
- When buying a property: You’ll need a copy of the contract of sale or a letter from your conveyancer to say you’re searching for a property.
- When buying shares: You’ll need a letter from your accountant or a statement of advice from your financial planner or a copy of the plan.
- When consolidating debt: For each of the debts you are repaying, you’ll need to show one recent statement.
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Words by Katy Holliday
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