Home equity loan
Home equity loans are a specific type of home loan. They allow you to access the equity (ownership) that you build up in your home over time. This can be important when your circumstances change.
What can you use a home equity loan for?
You can use a home equity loan for just about anything. Some of the most common are listed below.
- Home renovations
Even though your home may suit your needs now, it may not over time. For example, as your kids get older if you start a family. Renovating a home can be cheaper than moving. It can also increase the value of your home, provided you don’t overcapitalise.
- Debt consolidation
If you have other debts like personal loans or credit cards, you can consolidate them all into your home loan. This can help save you money because home loan interest rates are low. You therefore won’t be charged as much interest.
Debt consolidation also allows you to avoid the hassle of having to make multiple repayments. Instead you can just make your regular home loan repayment to cover all your debts.
- Deposit on an investment property
Many Australians use the equity that they have in their own home as a deposit on an investment property. This can be a great way to build your long-term wealth.
- Buying a business
Sick of your job? You can use a home equity loan to help you buy a business.
- Buying a car
Home loan interest rates are cheaper than car loans.
How home equity loans work
Home equity loans are usually one of two types:
- Line of credit
A line of credit home equity loan works like a credit card. You have a pre-approved limit that you can borrow against if you need to. You only get charged interest on the actual amount you borrow.
- A lump sum
A lump sum home equity loan allows you to borrow a lump sum using your equity as security. The equity (ownership) that you have in your home can be easily calculated. It’s the difference between your home’s market value and what you owe on it. For example, suppose you have a home worth $600,000 and you owe $350,000 on your home loan. Your equity would be $250,000 (i.e. 600,000 less $350,000).
Your equity in your home can build up over time in three ways.
- By your home increasing in value over time
As your home increases in value and the amount you owe on your home loan decreases, your equity further increases. History shows that Australian property prices tend to rise over the long term.
- By you making your regular home loan repayments.
Every time you make a home loan repayment, part of the amount repays interest and part repays some of the principal. The principal is the amount you originally borrowed.
- By making additional home loan repayments.
You can do this by making voluntary one-off payments when you can. For example, when you get a tax refund. You can also do this by converting your monthly repayments to fortnightly or weekly instead.
How can making fortnightly or weekly home loan repayments increase my equity?
When you convert your monthly repayments to fortnightly or weekly, you make sure you pay the same yearly amount. You can do this by dividing your monthly repayments by 2 if you want to make fortnightly repayments. If you want to make weekly repayments, divide your monthly repayments by 4.
Either way, it will help you to make extra repayments and build your equity in your home. That’s because there are slightly more than 2 fortnights in each month and slightly more than 4 weeks. The result is that you end up making an extra monthly repayment each year without even realising it. The table below uses a simple example to demonstrate.
|Repayment Frequency||Repayment Amount||Total Yearly Repayments||Total Yearly Extra Repayment|
How much can you borrow with a home equity loan?
The amount you can borrow on a home equity loan depends on four main factors.
- How much equity you have
The more equity you have, the more you’ll be able to borrow.
- Your lender’s policy
Different lenders will be prepared to lend different amounts. The amount your lender will approve will depend on their loan-to-value ratio (LVR) policy.
The LVR is the amount you owe expressed as a percentage of the value of your home. For example, if your home is worth $600,000 and you borrow $480,000, your LVR is 80% ($480,000 divided by $600,000). Some lenders may be prepared to accept higher maximum LVRs than others.
Some lenders may not approve a home equity loan higher than 80%. Others may be prepared to approve them for LVRs of 90% or 100%. However, the higher the LVR the lender is prepared to accept, the stricter the terms and conditions will be. For example, you’ll likely be charged higher interest rates and other additional fees with a high LVR.
- Your ability to afford the additional repayments
If you increase the amount you owe, your repayments will increase to ensure you pay off your loan on time. You can use our repayment calculator to work out your repayments for different loan amounts. You can also use our borrowing power calculator. It will give you an indicative idea of how much you may be able to borrow.
- Your credit score
If you have a good credit score, you’ll be more likely to be approved for any loan. This includes a home equity loan. Lenders check your credit score when you apply for a loan. You can develop a good credit score by making all your debt repayments on time.
The pros and cons of home equity loans
Are they a good idea? It depends on your individual financial situation and goals.
Home loan interest rates are lower than other forms of finance like personal loans or credit cards.
Home equity loans can help you with finance if your circumstances or needs change. It’s important to remember that a home loan is a long-term financial commitment. Standard home loan terms in Australia are 25 or 30 years. Your circumstances and needs are highly likely to change over such a long time. A home equity loan provides you with flexibility.
Home equity loans can help you to leverage your wealth if you borrow to invest in growth assets. For example, buying an investment property or a business. Both of these investments can help you to generate additional income and achieve capital growth. Capital growth is achieved when your assets increase in value over time.
Some lines of credit only require interest-only repayments. This can make your repayments more affordable.
When you borrow against your equity, you increase your debt. If you use the additional debt on expenses like a holiday or to buy depreciating assets, your wealth will decrease. Depreciating assets include cars. Their value decreases over time.
A home equity loan can have additional fees.
Your repayments will most likely increase. You should only borrow more if you can comfortably handle any extra repayment that’s necessary. Otherwise, you can potentially get yourself into a debt spiral.
Home equity loans involving lines of credit can tempt you to increase your debt if you aren’t financially disciplined.
If you increase the amount you owe, you increase your risk. You should always remember that a lender can repossess your home if you don’t make your repayments. Accessing your equity for risky purposes or frivolous spending can result in you losing your home.
Top tips to consider before accessing your home equity
Follow our top 3 tips before taking up home equity loans
Even though interest rates in Australia are at record lows now, there’s no guarantee they’ll stay low. Home loans are long-term financial commitments.
If you want to borrow more by accessing your home equity, always factor in the potential for future interest rate rises. You need to ensure you’ll be able to afford the additional repayments if it happens.
If you access all the equity in your home, what will you do if you have a financial emergency?
Accessing the equity in your home is a big financial decision, especially if you’re taking out a large lump sum. It’s best to seek independent financial advice about whether it’s a suitable option for you. This advice should be based on your specific financial circumstances and goals.