A home equity loan is a great way for homeowners to access extra funds. This type of loan can be used for a range of projects including non-structural renovations, a new car, an investment property and more.
How much equity is in your home, and how much you have owing on your mortgage, will determine the amount you can borrow. These loans are perfect for those who are looking to make a larger purchase or investment.
Here’s everything you need to know about home equity loans.
What is a home equity loan?
Home equity loans are a type of loan that allows you to borrow money against the equity in your home. The loan amount is based on the difference between the home’s current market value and the homeowner’s mortgage balance due.
Inovayt Finance Broker, James Christie, says, “The first step to getting an equity loan is the valuation of your property to figure out how much equity you have. This is done by your broker in conjunction with your lender.”
If you have enough equity in your home to take out a loan, the purpose of your loan will then be assessed.
There are so many things a home equity loan can be used for. Home renovations (non-structural), investment properties, investing in the stock market and other personal finances, such as getting a new car or starting up your own business, are all valid loan reasons.
The key reasons why someone may choose to use their equity are:
- Saving for a house deposit can take years. Because of this, many homeowners choose to use the equity in their existing home(s) to purchase an investment property. Depending on how much equity is in your home, you may be able to pay for the property in full, or a good chunk of it. This is a great way for investors to get into the market and build wealth.
- Many people dream of starting their own business. However, dreams can often come at a price – some that we may not have readily available to us. Using the equity in your home will allow you to achieve your business goals sooner.
- There comes a time when our houses begin to need a little bit of love. Non-structural renovations to things like the garden, kitchen or anywhere on your property can all be funded by an equity loan. For any structural changes, you’ll need a construction loan.
- For savvy investors, investing in the stock market is a great way to build your wealth. Using the equity in your home, you can add to your wealth by investing these funds. It’s a great opportunity for responsible investors with sound knowledge of the market.
Depending on what the purpose of the loan is, you’ll generally pay the same interest rate as you would on your property.
“If you’re borrowing against your owner-occupied property to do renovations on your owner-occupied property, your interest rate would be the same,” James says.
“If you’re borrowing against your owner-occupied property for investment purposes, the interest rate on that loan split would be dictated towards an investment purchase.”
Lower interest rates on this type of loan make for the perfect opportunity to consolidate debt to eliminate higher interest rates on credit card and personal loan debt.
For more information, read our blog on debt consolidation.
However, there are a few limitations when it comes to these types of loans that you need to be aware of.
What are the limitations?
Like most things, there are a couple of drawbacks and limitations to equity loans. The first is that it can’t be used to solve any cash flow issues.
“Anything to do with trying to borrow money to increase your cash flow generally doesn’t work, as you’re putting yourself into further debt,” James says.
The purpose of the loan is important and it is what lenders look at when applying for any equity loan.
Every lender you apply with will also re-evaluate your financial situation to see whether you’re able to repay the loan while still servicing any other loans or expenses you may have.
There is also a limit as to how much you can borrow, although it does vary based on the individual situation.
James says, “Generally speaking, you don’t want to increase your equity position above 80 per cent of the value of the property. Let’s use the example of a scenario where you purchased a property for $900,000 with a loan of $800,000. If, in 12 months, your property value went up to $1 million, and your loan was paid down to $780,000, that means you can raise equity up to 80 per cent of $1 million ($800,000). As your loan is $780,000, this means you have $20,000 of useable equity.” Some lenders may agree to draw out more equity, however, drawing out anything over 80 per cent means you will need to pay lender’s mortgage insurance (LMI).
What are the positives and negatives of home equity loans?
There are many positives to home equity loans, however, there are also a couple of key drawbacks worth noting.
- These types of loans are an easy way to access cash, as well as being a valuable tool for borrowers. If you have a steady, reliable source of income and know that you will be able to repay the loan, low-interest rates and possible tax deductions can make home equity loans a sensible choice.
- Generally, the interest rate on home equity loans is a lot lower than it is on personal loans, credit cards, or other types of consumer loans.
- You’re guaranteed a certain amount so know exactly what you’re going to get in one lump sum. Investopedia says, “Home equity loans are generally preferred for larger, more expensive goals such as remodelling, paying for higher education, or even debt consolidation because the funds are received in one lump sum,”
- James advises, “Subject to financial advice, some people who might be sophisticated share investors can borrow money at 3 per cent and get a 5 per cent return on that cash in the share market, so it’s a way that you could potentially increase your wealth.”
- These types of loans are often fairly flexible, so can be used for a number of things, including overseas travel.
- Some people may not understand that using equity is still borrowing money. Make sure you’re using the money for a certain purpose and not drawing the money out for something like home renovations but then spending it on something like living expenses, which will then burn up your equity. Ensure there’s a benefit to increasing your debt.
- One of the bigger disadvantages is owners are increasing the size of their debt when they borrow against their equity. This will mean higher monthly repayments to service which may take longer to pay back.
- Fees may apply if you change lenders and need to pay an exit fee with your current lender.
Home equity loans are great ways for homeowners who have built up equity in their property over time. Being able to borrow against your equity will allow you to access funds you otherwise wouldn’t be able to. As the purpose is important, you need to make sure you’re using the money for the right reason, such as non-structural renovations to your home, a car loan or for investing. Reach out to our team today to discover how you can secure an equity loan.