What Is a Home Equity Loan?

If you’ve been paying off your home for a few years you will have built up some equity. Put simply, equity is the value of the property minus the remaining debt, or what you still owe on it.

Say, for example, you bought a property for $500,000 five years ago and it has appreciated in value to $600,000, and your remaining mortgage is $400,000. You have $200,000 of equity in the property.

A home equity loan allows you to borrow against that equity.

How a home equity loan works

A home equity loan is similar to a personal loan in that it’s a set amount that has to be paid back in a set amount of time. It’s different in that it’s secured by your home’s equity, and typically at a lower interest rate than a personal loan.

To find out exactly how much equity you have, you could ask for a property valuation from your lender or organise one through a mortgage broker. Mortgages are relatively flexible these days, given the unprecedented levels of competition among lenders in the marketplace, and once you have a figure you will have a range of options for using that equity.

A financial planner should be able to help you think through your options and conduct a health check on your current financial situation to see if a home equity loan makes sense for you. And a mortgage broker can help you determine whether you have the best interest rate and other conditions for your existing home loan.

Always talk to your current lender before looking at other loan options and make sure you are aware of the fees and charges associated with a home equity loan. Once your lender has determined what you can borrow, processing the loan should be a fairly straightforward process that takes days not weeks to eventuate.

» MORE: How to build and increase equity in your home

How home equity builds

Building equity as quickly as possible should be the goal of all mortgagees, regardless of your financial status or the stage of your mortgage, because it pays down your mortgage faster and reduces your interest burden while simultaneously building a valuable asset.

There are two main ways to build home equity: reduce your mortgage and increase the value of your property. The less you owe the more equity you have so you should always be looking at ways to pay off your mortgage faster, such as making extra payments or finding a lower interest rate.

At the same time, a rise in the property’s value will increase your equity, so making renovations and improvements wherever possible will also help to build value.

Ways to use a home equity loan

Once you have built your equity you can then free that money up through a home equity loan.

What you choose to do with a home equity loan will depend on your financial circumstances and obviously what specific purpose you have in mind. Just be aware that any money you access from your equity goes back onto your mortgage and may put years back onto the whole payoff process.

Some home equity loan options:

Make home renovations.
Purchase a car.
Debt consolidation of higher-rate loans and credit card balances.
Invest in shares, bonds, managed funds or even crypto if you’re confident you can get a better return than the interest rate you’re currently paying on your mortgage.
Buy a second home or investment property.

When it comes to unlocking the value in your home, the most common purpose associated with equity is buying a second, or investment property. The beauty of this scenario is that, unlike your first property where you probably had to save for years for your deposit, you can use the equity as a deposit for your investment property, then rent it out to help pay off the mortgage.

How much equity can I borrow?

Before you go making plans, however, there are a few things you’ll need to know, especially how much of your equity you can actually borrow against.

As a rule of thumb, most lenders will only let you borrow up to 80% of the value of your property, as per your original mortgage where you were required to come up with a 20% deposit or make alternative, costlier arrangements.

So if, for example, you purchased a property for $500,000 and it is now valued at $600,000 and you still owe $300,000, you have $300,000 in equity. However, the new 20% threshold (or value of the property now) is $120,000, meaning the equity you can unlock is $300,000 minus $120,000 which equals $180,000.

Some lenders may be willing to offer you more but that will depend on your overall financial situation and your ability to service the mortgage going forward. Primarily they will look at your current income to determine if you could afford to pay off another $100,000 on top of that, for example, and may determine that you could only afford $50,000.

This is especially true if you’re using the money for another mortgage for an investment property, where your lender will want to know what the gap is between rental income and the monthly repayment figure and your total debt burden. In such a scenario, you may be able to access $200,000 in home equity but can only afford repayments on $100,000.

If you’re unsure how much of your equity you should access, it may be a good idea to talk to a financial planner or a mortgage broker. They can provide the information you’ll need for purchasing your investment property as seamlessly as possible.

Pros and cons of home equity loans

Taking out a home equity loan, like most things property related, has plenty of advantages and disadvantages.

The pros include:

The ability to access funds: As already discussed, taking out a home equity loan allows you to access your money for everything from renovations to buying a car, boat, holiday or anything you can think of. Importantly, it also allows you to potentially build wealth through buying another property or some other type of investment. Additionally, given you already have an established mortgage with your existing lender, the whole loan process for your investment property should be smoother and less time consuming than it was for your current mortgage.

Cheaper rates than personal loans or car loans: Unlocking home equity funds means putting money back onto your existing mortgage that you’ve already paid off so you can buy a car, for example, at a much lower interest rate than if you were taking out a personal or car loan to make the same purchase.

Renovations can increase your property’s value: It may seem counterintuitive to put more money back onto your mortgage, but there are situations where doing so could really pay off. If you’re using the money to renovate, for instance, you could greatly increase the value of your property, while also making it considerably more comfortable to live in.

The cons include:

Fees and charges: Home equity loans aren’t exempt from fees and charges but you may be able to minimise these depending on your lender and how keen they are to keep your business. At any rate, you should make sure you understand exactly what they consist of and what you’re in for over the term of the remainder of the mortgage.

Going back into more debt: Accessing your home equity could mean undoing years of fastidious saving to get to where you are now and, in many ways, you could feel like you’re back to square one, especially if you plan to use the money for a holiday, car or boat that you may not really need.

Possibly excessive interest repayments and financial hardship: Following on from the previous point, more debt means greater interest repayments and potential financial hardship if you lose your principal source of income and are unable to service your monthly repayments. Additionally, you should always be wary of the risks associated with taking on more debt if you plan to invest the equity in things such as shares or managed funds. Talk to a financial adviser or accountant if you’re at all concerned about the risks of this strategy.

» MORE: What is a reverse mortgage?

Alternatives to a home equity loan

Once you’ve established how much equity you have in your home, it is worth considering how that money could be used as a buffer in case of an emergency such as losing your job or needing an emergency medical procedure.

Before you take out a home equity loan you should consider how long the term of your current mortgage will be extended for, whether you’ll be able to make repayments if interest rates continue to rise and how you could cope under these circumstances.

Finally, you may want to consider other financial instruments. Some of these have age restrictions and their own financial drawbacks too, so once again you should talk to an expert before proceeding.

Home equity conversion: A home equity conversion loan is similar to a home equity loan in that it allows you, the property owner, to borrow against your home equity. However, the loan repayment and interest incurred is usually deferred until after the property is sold.

Equity release: Unlike a home equity loan, which allows you to borrow against the equity in your home, an equity release agreement replaces your current mortgage with a larger one. This allows you to take the difference in cash, which you can then use for any purpose you see fit, such as to pay for renovations or medical expenses.

Reverse mortgage: A reverse mortgage, which is only available to those 60 years of age or older, allows you to release the value of your home without having to sell it by trading home equity for cash. No regular repayments are required as the debt will be repaid from the future sale of the property, so you can continue to live in your home.

Home equity reversion: A home equity reversion scheme in Australia is a contract for the partial sale of your home. This means you sell a share of the future sale price in exchange for a lump-sum payment. This involves selling a percentage of your home equity at a discount to its current value and the reversion scheme provider receives the value of the proportion of the property it purchased upon sale. Home reversion schemes are currently only available to those 55 years of age and older.

» MORE: Types of home loans