Ultimate guide to home equity loans: What is a home equity loan and how does it work?

A home equity loan lets you borrow against your equity. Find out what home equity is and how a home equity loan helps you unlock new opportunities.
joseph@itssimple.com.au

joseph@itssimple.com.au

November 24, 2022

Ultimate-guide-to-home-equity-loans-in-Australia

If you own a property, a home equity loan allows you to borrow against the equity you’ve built in your home. You can use your equity to fund your home renovation, invest in a property or purchase big-ticket items, such as a car.

But what is equity, and how can you tap into it? Find out how a home equity loan can help you unlock new opportunities and grow your wealth.

What is a home equity loan?

what-is-a-home-equity-loan

A home equity loan is a type of mortgage that allows you to borrow against your equity.

To put it simply, equity refers to how much of your home you own. To calculate your home equity, take the difference between the current market value of your property and your outstanding loan amount.

For example, the current market value of your property is $750,000, and you still owe $400,000. This means that your raw equity is $350,000.

How does a home equity loan work?

When you take out a home equity loan in Australia, it’s important to remember that you may not be able to use your entire equity. Typically, depending on your financial circumstance, a bank or lender will let you borrow up to your usable equity.

Your usable equity is calculated as 80% of your home’s current market value minus your outstanding loan balance. Taking the example above, your usable equity is $200,000:

Property’s current market value: $750,000 x 0.80 = $600,000

Outstanding loan balance: $400,000

Usable equity: $600,000 – $400,000 = $200,000

To help you better understand how you can tap into your equity, It’s Simple Finance’s managing director, Joseph Daoud, explains how home equity works:

How can you access your home equity? 

There are several ways you can tap into your equity:

Line of credit

A line of credit loan allows you to access your home’s equity up to the approved limit and only pay interest on the amount you withdraw. Similar to a credit card, this gives you the flexibility to borrow and repay up to the available limit.

Lump sum

You can borrow a large sum of money and use your equity as security. Similar to how home loans work, when you borrow a lump sum, you make the necessary repayments including the interest.

Refinance

Arguably one of the most common ways, refinancing your home loan either with your current or a new lender allows you to access your equity. It’s important to note that your lender will likely order property valuation to determine whether your property’s value has risen or fallen since you purchased it.

Cross-collateralisation

Cross-collateralisation is when you use your equity in one property to buy another property. This is considered a risky practice since both properties act as security for the loan. So, if you fail to meet your repayments, you can potentially lose both properties. Seek advice from finance or tax experts to ensure you don’t risk your assets.

Redraw facility

If you have this loan feature, you can access any additional repayments you’ve accumulated on your home loan.

How can you use a home equity loan?

how-can-you-use-a-home-equity-loan

Depending on your financial circumstance, you may be able to access your home equity to:

Renovate your home

Borrowing against your equity can help you fund your renovation, repair or remodel. By doing this, you not only make your home look better but also increase your property’s value. In a way, you reinvest the money into your property. 

Invest in a property

Tapping into your equity also unlocks possibilities of starting or expanding your investments. If your home has increased in value, you can access your equity to invest in properties, shares or bonds to build your wealth.

Fund personal expenses

You can use the equity to purchase a car, pay for special occasions (i.e. weddings) or even go on holiday for a lower rate. Your home loan equity allows you to fund your personal expenses without worrying about taking out a personal loan with a higher interest rate.

Consolidate debts

Managing your debts can be stressful. If you’ve built enough equity, you can consolidate your debts to combine your monthly repayments into one, simplify your loans and relieve yourself from this burden. Plus, you may save on the interest you pay since home loans come with a lower rate than personal loans.

Advantages and disadvantages of a home equity loan

advantages-and-disadvantages-of-a-home-equity-loan

Advantages

Home equity loans can be a good choice as long as you’re responsible with your finance. They provide a source of cash that can come in handy when you need extra funds. This way, you avoid dipping into your savings.

Aside from the ease of access to funds, a home equity loan is also a cost-effective way of borrowing money since it comes with a lower interest rate compared to personal loans, such as credit cards.

When you use your equity to improve your home, you potentially increase the value of the property. As a result, you build more equity and expand your options.

If you’re looking to grow your investment portfolio, it’s also a wise choice to take out a home equity loan. With your access to your existing equity, you can build your investment without waiting years to save for a deposit.

Disadvantages

Even if a home equity loan seems promising with the flexibility it offers, it also comes with drawbacks that you should be aware of before committing to it.

One of the biggest dangers of this type of loan is losing your home. Since you borrow against how much of your home you own, you risk property foreclosure if you fail to meet your mortgage repayments.

Keep in mind that a home equity loan means more debt, so your repayments will increase. Before dipping into your equity, make sure you have enough financial buffer to avoid defaulting on your loan in case you face a tough situation.

If you take out a home equity loan to improve your property, there’s still a chance that the renovation does not increase the value of the home. In this case, you can end up owing more than what your home is worth. Negative equity happens when the market value of your property is lower than your outstanding home loan balance.

How to build equity in your home?

how-to-build-equity-in-your-home

Equity increases and decreases along with the market value of your property, so building your equity means you lift the difference between your outstanding balance and your home’s value. Fortunately, there are some steps you can take to improve your equity:

  • Make carefully planned home improvements (renovation, upgrades, expansion, etc.) to increase the value of your property. 
  • Make larger or more frequent repayments to decrease the gap between your loan balance and your home’s value, but make sure that this feature is available on your home loan. This way, you increase your equity and pay off your mortgage earlier.
  • Consider using your offset account. Any amount you store in your offset account is reduced from your loan balance. Through this, you save on the interest while building equity. You can use our loan repayment calculator to work out how much you can save.

When is a good time to use a home equity loan?

Just like any other loan, taking out a home equity loan depends on your needs and goals. This type of loan may be right for you in these circumstances:

  • You have enough equity in your property.
  • You want to have an additional source of funds without taking out a personal loan or selling your property.
  • You want to start or diversify your investment portfolio.

What you need to know about home equity loans

What are the qualifications?

The most important qualification is that you have enough equity saved in your home. Note that you can’t access the equity that you don’t have. Each lender has a set of criteria you should meet to be eligible for a home equity loan, so it’s best to talk with your broker to see if you qualify for the loan.

How to apply for a home equity loan?

Aside from determining your goals, you should take the necessary steps before applying for a home equity loan:

1. Work out your goals

First and foremost, you should know why you want to tap into your equity. This will help you have an idea about how you want to access your equity and make clearer decisions about what to do.

2. Know the current market value of your home

The most crucial step you should consider is finding out whether your property’s value has increased or decreased since you bought it. Understanding the current market value of your home can help you determine how much equity you have.

To help you have an idea, you can get your FREE property report instantly.

3. Reassess your situation

After finding out your usable equity and what you want to do with it, work out how much money you need to achieve your plans. For example, if you’re using your equity to buy a car, make sure you do the maths to ensure you can pay for both loans. This can help you carefully plan and consider how you can make any additional repayments without experiencing mortgage stress.

4. Compare your options

Just like a normal home loan application, it’s smart to consult with home loan specialists to have expert guidance throughout your application. It’s Simple’s mortgage brokers can help you assess your situation, check your rate, know your options in the market and work out any fees you need to pay.

5. Apply and settle 

Then, you only need to submit the documents required by your lender, and your It’s Simple broker will handle your application from start to beyond.

How long does a home equity loan take?

If you’ve already built enough equity in your home, it’s quite easy to apply for a home equity loan. But just like other home loans, accessing your equity can take days to weeks depending on your lender and situation.

For example, if your lender orders property valuation, this can affect how long your application will be before it gets approved. This is where brokers can help you. They may be able to speed up your application by making sure that there aren’t any errors or missing documents that can impact your approval.

How much home equity loan can you take out?

The amount of equity you can take out depends on your property’s market value, your loan balance and your lender. Generally, banks and lenders let you borrow up to 80% to keep your loan-to-value ratio (LVR) under 80% to avoid paying lenders’ mortgage insurance.

When you apply for a home equity loan, your lender will assess your financial circumstance and property to determine if you can borrow up to your usable equity (80% of your home’s current market value minus your remaining loan balance).

Is a home equity loan for you? 

If you have enough equity in your home and want to access extra funds, a home equity loan may be worth considering. But since a home equity loan means acquiring more debt, it’s not for everybody, so you should be cautious when pulling out your equity.

It’s important to assess your financial situation and goals and consult with experts to make sure you make your equity work for you. This way, you not only generate more wealth or achieve the lifestyle you want, but you also avoid risking your property.

To make all of this easier and faster, It’s Simple Finance’s mortgage brokers are always happy and ready to help you get a loan with comfort and confidence. Book your FREE consultation now to access the top 40+ banks and lenders in Australia that match your lifestyle and goals.

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joseph@itssimple.com.au

joseph@itssimple.com.au

joseph@itssimple.com.au

joseph@itssimple.com.au

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