While in today’s uncertain financial times, it’s can be difficult for many people to borrow money for a renovation or investment property or to consolidate debt, those who’ve worked hard to pay down a mortgage have one strategic advantage.
Many people don’t realise that by paying off a property that is either holding or increasing in value over time, you also build what’s called home equity. And it is this equity you can leverage to potentially access the money you need. Here’s how
Simply put, home equity is the difference between what the market will pay for your home and what you still owe on your mortgage. For example, if your home is valued at $400,000 and you still have $250,000 left to pay off your home loan, your home equity is up to $150,000.
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The term home equity loan is a general name given to a number of loan products where you can borrow against this home equity. This means you essentially use this equity as collateral for a loan. It’s a way to show potential lenders you have the ability to pay off any loan product you might take out with them.
Home equity loans can include such products as line-of-credit loans, 100% offset home loans, variable-rate mortgages with a redraw facility or even the refinancing of your existing home loan.
How the loan will work varies widely, depending on the type of loan you are taking out and the specific rules of the lender, but they still operate under the same processes as other loans, remembering that the term home equity loan is a general one.
Rules and processes for home equity loans vary across banks and institutions. Some also have specific limits on the amounts they will approve for home equity loans, though this is not the case with all lenders. Most lenders will let you cash out the equity up to a total of 80% LVR without incurring Lenders Mortgage insurance.
You can refinance and cash out above 80% – up to 90% inclusive of LMI but you would need a strong application and a good reason to do this as its usually not cost effective.
You may also want to use your property as security if there is equity to refinance and purchase an additional property if there is equity.
Generally, home equity loans should come with lower associated costs than with other forms of credit, because you are borrowing against equity you have built. But always check this with your potential lender.
While home equity loans can be used for just about any purpose, most banks and financial institutions will ask you what you are using the released value for and may reject your application if they feel the purpose is not justified.
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First and foremost, you will need to have built some equity into your home by going through a period of paying off the principal of your mortgage.
If you only recently started making repayments, or are perhaps in an interest-only period on your loan, you may not have built enough equity yet to apply for a home equity loan.
In general, most banks will try to ascertain if you’re using the money in what they see as a responsible way and as with any loan they make will carefully assess your ability to pay off the debt.
The higher the proportion of your total debt you’re borrowing, the more evidence most lenders will require that you’re using the funds in a responsible way, as well as of your capability to pay it off. You should be prepared to provide evidence of your income and expenditures.
If you’re self-employed, providing the required documentation can be difficult. In these cases, it may be harder to get a loan, but some lenders can have lower evidence thresholds, so it pays to shop around.
One example of a home equity loan is the 100% offset home loan. This is a home loan where borrowers can reduce their interest payments through what is known as an offset account linked to their mortgage.
Borrowers can use the offset account as if it were a savings account, making deposits and withdrawing as they need.
The key is that the amount kept in the account is deducted from the total you owe when interest is calculated on the loan.
For example, if you have a loan of $500,000 and have $10,000 in your offset account, interest on your loan is calculated on $490,000, not the full $500,000.
So, the more you keep in the account, the lower your interest payments. This type of loan may not suit everyone, as you need to maintain a certain level of money in the offset account, depending on prevailing interest rates, to gain any reasonable benefits. And you have to also ensure you have sufficient funds to cover your mortgage payments.
Some lenders also may not offer offset accounts for fixed-rate home loans and many big banks don’t offer offset accounts on their basic home loans under $250,000. But some smaller institutions do, so it’s always worth asking if you feel it would suit you. As always, investigate your individual situation carefully before making the choice.
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Most lenders will state that a home equity loan can be used for any “worthwhile” purpose. These purposes can include renovating your home, paying for a holiday or medical expenses, purchasing another residential or investment property, consolidating your debts into a single loan, buying a business or even buying stocks and shares.
Always keep in mind that the lender will assess the risk of each application individually. Of course, lenders will not provide loans for illegal purposes, but some may allow a loan when refinancing to pay a debt to the tax office, for example.
Borrowing more money of course means you have increased your debt and therefore the repayments you owe. It’s essential you discuss with your potential lender what all your new costs are and how you will pay it all back.
In some cases, lenders may require you to pay Lenders Mortgage Insurance (LMI), especially if you’re bringing your total borrowings up to 90 percent of your home’s value.
There may also be other costs and charges involved with opening a new loan and with any loans you may be closing early as a result.
These loans are also unavailable to people who have not yet built enough equity in their home, for example because they only recently took on their mortgage.
Equity is only built after a period of time paying back the principal of a mortgage. People who, for example, take an interest-only period on their loan, will not be building equity during that time.
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Just as with any other loan, the most important factor to consider is your ability to pay it back.
If you are responsible with your finances and seek to borrow an amount you know you can afford, a home equity loan can be a quick, cost-effective option if you need some extra capital.
They can be an especially good option if you’re consolidating other debts into your home loan, as the interest rates on mortgages can tend to be lower than other types of credit. But it all comes down to your personal circumstances.
The sort of evidence you need to provide regarding the purpose of your loan depends on how much you are looking to borrow, what percentage of your total debt this represents, the purpose of the loan and which lender you’re applying to.
Processes vary across lenders, so make sure you ask them what conditions they put on their documentation requirements.
Here are some examples of what you might have to provide for various scenarios.
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Words by Erin Delahunty
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