Learn the ins and outs of these products and how they can be used to finance your next investment.
A home equity loan is a loan in which you put your property up as security to borrow against the equity of your home. Equity represents the value of your home which you own outright and consists of the amount of cash you have repaid on your loan as well as capital growth. In other words, if you took out a loan of $430,000 for a property valued at $500,000 and now that property is worth $540,000 and you repaid $120,000 of your loan, then you have $230,000 worth of equity in your home.
Lenders will allow you to access this money through a home equity loan such as a line of credit loan but the majority will only let you borrow a percentage of the total equity value because you’re essentially signing away a portion of the ownership of your property and if you default on the loan or miss a payment, there’s a good chance you could lose the property to the bank. This article will examine in-depth how a home equity loan and in particular a line of credit, can be used.
Comparison of Home Loans
Rates last updated December 5th, 2016.
- NAB Portfolio Facility (LOC) - $500,000 to $999,999
Interest rate decreased by 0.10%
August 19th, 2016
- NAB Portfolio Facility (LOC) - $250,000 to $499,999
Interest rate decreased by 0.11%
August 19th, 2016
- What are the advantages of a home equity loan?
- What are the disadvantages of a home equity loan?
- What can a home equity loan be used for?
- What are the different types of home equity loans?
- How much of my equity can I access?
- How to choose a home equity loan or line of credit
- Common features of a line of credit loan
- How to use a line of credit or home equity loan to invest in property
What are the advantages of a home equity loan?
One of the main advantages of a home equity loan is that it allows you to borrow money at a lower interest rate when compared to personal loans, credit cards and margin loans. This is because you're using your property as security, meaning you pose a lower risk for the lender. If you default on your loan or stop making your payments, the lender won't necessarily lose their money because they can take your house and sell it off, ensuring they won't suffer a loss.
Of course, another benefit is that you can take advantage of the equity that has built up in your property, which you could otherwise not access except by selling your home.
What are the disadvantages of a home equity loan?
One characteristic of a home equity loan, as with any other loan in which you put up security, is the fact that you're risking the same asset you're using as security. Essentially, by taking out a loan against the equity in your home, you're reducing your level of ownership of the property, which means you could be throwing all the hard work of having paid off part of your loan out the window by using the money for other purposes. In other words, if you do take out a home equity loan, make sure it's for a very good reason.
Another disadvantage of the home equity loan is that you're increasing the principal you have borrowed, which can lead to higher interest costs and the payment of a number of fees, including refinancing fees, application fees and Lender's Mortgage Insurance (LMI) premiums.
What can a home equity loan be used for?
A home equity loan can be used for practically anything but you need to keep in mind that you're exposing yourself to a fair bit of risk, especially if you aren't able to cover your repayments at any point. If you've done your due diligence and have budgeted effectively, the equity in your home can be used to help you achieve various goals in your life. You must make sure that you're taking out the home equity loan for a very good reason.
One reason to take out a home equity loan would be to help you consolidate existing debts. If you have a number of loans that are costing you a bundle in interest- we're looking at you personal loans and credit card debt, a home equity loan could be used to pay these off at a cheaper rate of interest. This means that you could save a lot in interest costs because the rates on home equity loans are much cheaper. You'd also be able to pay your credit card debt off faster and remember the interest on a home equity loan can be tax deductible while interest on personal debt isn't.
Additionally, through debt consolidation you'll have only one payment each month to worry about, which can lead to further savings. This because you'll no longer be paying annual fees for your credit card or other loans.
It can be a good idea to separate the home equity loan being used to consolidate your debts from your regular home loan because the last thing you want to do is pay off your personal debts for the next 30 years, which might negate any benefits you might have otherwise enjoyed from the lower interest rate.
Let's say you have $15,000 in credit card debt at 18% p.a. in interest. Even if you're making more than the minimum payment every month, it'll still take you awhile to pay off your debt and the interest charges will add up. So if you're paying $350 per month, it'll take you almost six years to pay off your credit card and cost you $9,200 in interest. And that assumes you never touch the credit card again.
If you use your home equity loan to pay off this debt but don't separate it from your home loan and have 25 years left on your mortgage that means it'll take you another 25 years to pay off your credit card debt. Even at an interest rate of 8% p.a., you'll be paying $19,730 in interest alone.
On the other hand, if you separate your home equity loan, you can still continue to make the same payment of $350 per month but at 8% interest, it'll take you a little over four years to pay the same debt off and you'll only be paying $2,700 in interest. That's a saving of $6,500.
You can also further increase the equity in your home with the help of a home equity loan by making improvements to the property or renovating it. Most renovations and improvements will lead to an increase in the value of a property, which will automatically mean the level of equity will also increase.
Before you attempt to make any improvements, though, it would be a good idea to talk to a professional property valuer, especially if your main goal is to increase the value of your home. A professional will be able to tell you exactly what will and won't work for your area. For example, certain things like rebuilding or expanding the kitchen will likely increase the value of your property, allowing you to recover your costs, but having a pool installed might not be right for your area or might simply be too specific to have an overall effect on the value of the property.
A home equity loan can also be used to start a business or for investment purposes, especially if you're focused on assets whose value will appreciate in time. For example, using the equity in your home to invest in other properties can be an excellent long term strategy. Not only will a new property increase in value over time and start to build up its own equity, but it can also be rented out, which will help to pay off any loans you used to purchase it and help you build equity faster in both properties.
Keep in mind that you do have another option when it comes to taking out a loan for investment purposes. The margin loan has one major benefit over a home equity loan and that is the fact that you won't be putting up your property as security but you'll still be getting a relatively competitive interest rate in most cases. Most lenders will evaluate your business plan to determine the level of risk involved. If it's too risky, they're unlikely to lend you the money.
Equity loan no-no's
One thing you don't want to use your home equity for is to purchase luxury items. Things like TVs and cars depreciate quickly and you'll be using debt to pay for them, which means even they'll cost even more due to interest.
You also might be tempted to use your home equity to pay off bills and other everyday expenses, thinking that you're solving a problem. If your equity runs out you'll find yourself in an even worse situation because you now also have home equity loan payments to add to the tally. You're much better off cutting back and learning how to live within your means. In other words, pay off your debts and obligations before you go shopping for the latest pair of Manolo Blahniks and cook dinner at home instead of picking up the phone to order takeaway again. It's the small things that make a difference in the end and you'll soon find you don't need to use the equity in your home to pay your everyday expenses.
What are the different types of home equity loans?
In Australia, there are only a few types of home equity loans, including the line of credit, reverse mortgage products, shared equity loans and more.
A line of credit is the most flexible way you can access the equity in your home because it is structured as a revolving loan, meaning you can access the money, pay it off and then use it again. One advantage of this type of home equity loan is that you can use the funds when you need them and only pay interest on the outstanding balance. It's an ideal option for a renovation or investing because you only use what you need when you need it, and can avoid paying interest on the money you aren't using. When applying for a line of credit, you'll receive approval for the entire amount of equity in your home and you can withdraw funds as needed.
When you apply for a line of credit loan, you can receive a lump sum, which then needs to be repaid in monthly instalments.
A reverse mortgage is a product which allows you to borrow money against the equity you've built in your home. They're generally offered to seniors trying to access funds in their retirement, and more can be read about them here.
Shared equity loan
This is usually a component of a loan where no interest is charged. It may be added onto a regular home loan to increase the amount you can borrow, but in exchange for not having to pay interest, you share some of the capital gains you make from the property when you sell it.
How much of my equity can I access?
Generally, most lenders won't allow you to take out a home equity loan that'll surpass a loan to value ratio of 80% in total, when combined with your existing mortgage. This means that the total amount you owe on your property cannot exceed 80% of its total value. This is because there's a chance that property values may fall and you could end up owing more on your home than it's worth if you borrow more than that. In the event you're able to borrow more than 80% of your property, this will come with the aforementioned Lender's Mortgage Insurance (LMI) charges.
Also keep in mind that the more you borrow, the higher your repayments will be, the more you will pay in interest costs and the greater the risk to your home will be.
To calculate your LVR so you can get an idea of how much you could potentially borrow, divide the amount you owe on your property by its total value. So, if your property is worth $200,000 and you owe $110,000, your LVR is 50%, which means you can access another $50,000, taking your LVR to 80%.
How to choose a home equity loan or line of credit
A good place to start when selecting a home equity loan is to research what's available in the market. The home loan market is highly competitive because lenders like the fact that they're lending out money against security, which means there is lower risk involved for them. This means that there are plenty of great offers available so you need to compare them to make sure you are getting the best possible deal.
Interest rates and loan features differ so you want to compare the offers in the market before making a choice. Also, don't forget to speak to your current lender as well. Show them what you've found in terms of other offers and give them a chance to make you a better offer. They might surprise you and it'll save you a lot of time and hassle, especially if you have to close out your current mortgage which could involve additional fees.
Common features of a line of credit loan
Line of credit loans tend to be a unique product due to the features they offer.
- Withdraw money as you need it. A line of credit is structured differently to a standard loan because you'll be withdrawing money as you need it up to a certain limit instead of receiving a lump sum. If your credit limit is $50,000, you might use only $30,000 and you will only pay interest on that $30,000 and that's the amount you will be repaying over the duration of the loan. You can then take out more and the repayments will change accordingly.
- Pay interest-only on what you use. As already mentioned, another unique feature is that you pay interest-only on the money you have used. So, if you don't use all the money, you won't pay interest on the full amount.
- Interest-only payments. You also have the option of making interest-only payments, which can be a great advantage if you will be using it for investment purposes. This way, you can pay only the interest, until a rental property starts generating income, for example, which will ensure you won't have any cash flow issues.
- Additional repayments. Most line of credit loans generally allow you to make extra payments to pay off your debt sooner.
How to use a line of credit or home equity loan to invest in property
If you want to succeed at property investment then you need to remember a key concept, namely that you want to expand your investment while using as little of your own money as possible. A good investment should be self-financing whether it's through rental income or tax deductions and should certainly not cause you cash flow problems.
On the other hand, you need to spend money to make money when investing in properties but the idea is to access funds you weren't even aware of, namely the equity in your existing property. You can use this money to invest in a new property, which can then start paying for itself. Your equity in the new property will increase as well as in your home the more payments you make and the more property values rise. You can then use the equity in both properties to finance the purchase of another and so on and so forth.
If you do your research correctly and choose the right investment properties, you can expand your portfolio and see significant growth without ever having to use large amounts of personal funds to finance your investments and without affecting your cash flow.
As mentioned in most cases you won't be able to access the full amount of equity in your property as lenders will generally not let you borrow more than 80% of the total value of your property.
If you want to use your equity to invest, you can go down two routes. You can either take out a line of credit or you can opt for a lump sum release of funds. In the first case, you'll have a preapproved limit based on the amount of equity in your property and you can access the funds whenever you need them. Any repayments you've made towards the principal can also be accessed, much like a credit card. Since you'll be using your home as security, you will generally be approved for a line of credit that, when combined with your mortgage, represents between 60% and 80% of the property value.
As mentioned, in some cases you can even get access to your full line of credit amount as a lump sum. This will mean you'll pay interest on the full amount straight away.
You'll also have to show the lender why you want access to your home equity and you'll need a good reason. Lenders don't want to release money to you if you don't have any plans to use it and simply want to have it available for the future. They don't make money if you aren't using the funds, especially when it comes to a line of credit, so they've become stricter when it comes to approving home equity loans.
Before taking out a line of credit home loan, if you plan to do it by refinancing, make sure to check what the exit fees will be for your current loan. You need to factor in all the costs and see if it's worth refinancing or if you are better off applying for a home equity loan. Keep in mind you might need to pay things like:
- Application fees;
- Legal fees to discharge the current mortgage on your home;
- Stamp duty;
- A new valuation of your property;
- Other legal costs and solicitor fees may also be involved.
Some of the costs associated with taking out a line of credit loan are better explained further below.
What are the advantages of a home equity line of credit loan?
A line of credit loan has an advantage in that you can use the money for practically anything you choose, which is why investors favour them. You can purchase a property and renovate it with the same loan, without having to apply for a new one.
There are also other positives:
- You only pay interest on the outstanding balance
- Easy access to funds when you need them
- You can reuse funds from your repayments
- It has a lower interest rate than a personal loan or credit card
- It can be used for many purposes
What are the disadvantages of a line of credit loan?
While there are plenty of advantages when it comes to line of credit loans, there are also some disadvantages, as is the case with any financial product.
Firstly, if you can't stick to a budget, then you might want to steer clear of this type of loan because it doesn't come with a clear repayment structure, which might make it difficult to pay off the loan for less disciplined borrowers.
You'll also find that line of credit loans tend to carry higher interest rates than standard home loans because of its flexibility. Since you don't need to make any payments towards the principal or even if you do, you can reuse those funds, there's a higher chance you'll take longer to pay off the loan.
There are other disadvantages as well:
- Can lose your home if you default on the loan
- No guarantee your investments will pay off
- Can end up with no equity in your home
- Your home could end up being worth less than your loan amount if property values fall.
How do I apply for a line of credit or home equity loan?
Applying for a line of credit loan or home equity loan is much the same as a regular home loan. You'll need to contact your lender, fill in your application forms and have your property valued. Once the valuation is complete your lender will work out how much they can lend you and if they can approve your application.
What will a line of credit loan or home equity loan really cost?
At first glance, you might be tempted to access the easy cash your home equity represents to go travelling or to make an investment or to work on your home instead of saving the money you need. After all, many financial advisers will say that it doesn't make sense to save money while you have a mortgage because the interest rate on your savings doesn't come close to the rate you're paying on your loan, so you should be putting all your available cash into your loan.
The only way to know if this is true is to look at the real cost of a home equity loan as well as your personal situation. The first step in figuring out what a home equity loan would cost you is to look at the comparison rates rather than the interest rate alone. The interest rate tells you how much you'll be paying above the amount you borrowed but the comparison rate includes all the fees you'll have to pay throughout the year. Every lender in Australia must provide a comparison rate for all the home loans they have on offer and it's an easy way to figure out how much the loan will really cost you.
Don't forget about one-off fees such as stamp duty, application costs, valuation and legal fees and son on and so forth. Since they aren't part of the ongoing cost of a loan, they aren't included in the comparison rate but can be as much as 5% of the total value of the loan and that's a cost you have to deal with before the loan is even approved.
If your loan has various features there could be costs associated that aren't included in the comparison rate. For example, redraw or additional payment fees won't be included so the true cost of the loan will depend on how you intend to use it. If your plan is to make additional payments to reduce the principal as quickly as possible and save on interest costs, then make sure you can make these payments for free.
Since interest rates and fees can differ a lot between lenders and by doing a little comparison shopping you can save hundreds of dollars every year. Keep in mind that when it comes to interest rates, in some cases the lower your LVR, the lower your interest rate will be so if you can save up for a larger deposit, then you can enjoy a much lower rate which can translate into thousands of dollars saved.
Remember that while you have every right to use your home equity, make sure you use it wisely. If you want to invest in assets that'll appreciate or bring you additional income or you want to renovate your home to further increase in value, then using your home equity could be a good choice. However, unlike a savings account, once you've taken out a home equity loan, you have to start paying it back right away and if you miss payments or default, you could lose your home. This means that you really need to think things through before applying for a home equity loan.
Six top tips
- Avoid having your line of credit fully draw. This gives you access to emergency funds.
- If you receive a credit card with your line of credit think twice about using it.
- Get your salary credited directly to your line of credit account. This will work to lower your balance and allow you to save in interest.
- Think carefully about long loan terms. A longer loan term will mean lower repayments but it will result in a higher overall loan cost.
- If you think you may change homes before the end of the loan term, you also want to look at exit fees because the last thing you need is to pay tens of thousands of dollars in penalties because you're paying off your mortgage early.
- Make all of your repayments on time to ensure a good internal credit score with your lender.
Frequently Asked Questions on a line of credit
What is a line of credit loan?
A line of credit or home equity loan is an amount of money you can borrow using the equity in your home, which represents the difference between the value of your property and the amount you owe on it. Your property will be used as collateral for the loan.
How to calculate the equity you can use for a home equity loan.
First, you need to calculate the loan to value ratio, which you can find out how to do at the beginning of this guide.
For example, if your home is appraised at $250,000, then an LVR of 80% would be $200,000. That's the amount you could potentially borrow if you didn't owe anything. From there, you need to deduct how much you have left to pay on your mortgage. So, if you still owe $90,000 on your home, then you can potentially borrow $110,000. Note that you will have to use your home as security.
What are the repayment terms of a line of credit loan?
A line of credit generally has no set repayment time, meaning you can greater control your financial situation.
What is the maximum LVR?
The maximum LVR is usually 90%. However, the majority of banks may limit the LVR to 80%. Remember borrowing over 80% may also require you to pay Lender's Mortgage Insurance (LMI).
What are the minimum and maximum amounts that can be borrowed?
This will depend on the lender you choose to go with. Westpac's Equity Access loan has a minimum amount of $25,000, while the ANZ Equity Manager Home Loan has a minimum of $20,000. Both have a maximum of $10,000,000, although the actual maximum amount available will depend on your personal circumstances.
How long does the approval process take?
Between one and two weeks depending on various factors.
Are there any fees involved?
The fees you'll pay will depend on the specific product. Some products might have an application fee which can be as high as $600. Add to this the possibility of valuation fees. which can range between $100 - $200. Finally, there could also be a service fee and an exit fee which can be as high as $250.
Will a valuation be necessary?
This depends on the loan amount and your eligibility. In some cases a full valuation may be necessary but this will depend on the lender and the type of product.
What type of interest rate does the home equity line of credit carry and how is it calculated?
The home equity line of credit generally has a variable interest rate.
How can I access the funds from my line of credit?
For the majority of home equity line of credit loans funds can be accessed via telephone and internet banking or by transferring them to a savings or chequing account.
A line of credit can be a good way to get access to your equity, but it's not without it's risks. Read our guide on line of credit loans to learn more about how they can be used.