Home equity is the difference between the amount you owe on your loan, and the amount your home is worth. Building equity is like saving, but without you having to do a thing. Your home increases in value without you have to do anything other than maintain it, and as long as you pay your loan on time each month, the principle amount owing will be going down.
For example, if your loan is for $200,000 and a house of the same size and style as yours sold for $300,000 around the corner then you have around $100,000 of equity in your home, which is the part of your home owned by you, not the bank, and is yours to do with as you please. With your mortgage schedule in place and property prices rising steadily on their own, you can continue to passively build equity in your home.
However, if you want to increase the gap between what you owe and what you own, then there are several easy ways to do it:
- Put down a larger deposit. If you haven’t bought your home yet but you want to build equity fast, then put down a larger deposit. This will immediately reduce the amount you owe, and increase the gap between what the property is worth, even if you’ve just bought it.
- Make additional repayments. Any amount you pay to your mortgage above the minimum monthly amount will go towards reducing the principle amount owing. As a result, you are also reducing the term of your loan because you now don’t have to pay back as much, so you’re not only building equity but saving interest too.
- Improve your home. The value of your home is dependent on the area and the sales of other houses in that area, but also on the features of your home. Therefore, when you make improvements to your home you increase its value, and increase the gap between what you owe and what you own. For example, you can improve the kitchen or bathroom, or add a pool, but just make sure you don’t spend more that the value you’re getting back, which is known as overcapitalising.
Benefits of a Home Equity Loan
From the time you fell in love with your home, long before you signed the loan papers, your dream has been to own it, and in building equity you are moving further towards that goal, and further away from being tied to the bank.
You can also benefit from a home equity loan by:
- Consolidating debts. When you have enough equity in your home, you can approach your lender to refinance your loan and draw down on the available equity. If you have credit cards and other debts, it can make good financial sense to use your equity to pay off these debts, and consolidate them into your home loan. You are then making just one payment each month, paying less interest and increasing your cash flow.
- Tax deductible interest. In some cases, the interest you pay on your home equity loan can be tax deductible, unlike the interest on credit cards or personal loans.
- Improve your home. You can draw down on a portion of your home equity to further improve your home, and in turn increase the equity again. For example, if you draw down $5,000 to supplement the $5,000 you’ve already saved for the new kitchen, then you can increase your equity by at least $15,000 as a new, quality kitchen is of major value to home buyers.
- Borrow up to 80%. When you have equity available in your home, your lender doesn’t want you to owe more than your property is worth either, that is why you will usually be able to borrow up to 80% of the equity available.
Features of a Home Equity Loan
Your home equity loan will have all of the same features as your original loan, because it is the same loan, it simply now has a higher principle balance. When you take out a home equity loan you are extending the loan amount so that you can access equity you would only otherwise be able to access if you sold your house. Since you want to stay in your house, but use the equity amount, you need to borrow that amount from the bank too, and so your repayments will also change to reflect that.
Who is Suited to a Home Equity Loan
You may want to consider taking out a home equity loan to renovate or improve your home. You can also use the equity in your home to pay for household expenses such as a holiday, or your child’s education. Home equity can also be used to pay off other high interest debts. To use your home equity for other investments, put it towards a deposit on an investment property or to buy a second home such as a holiday house.
While you are considering if you are suited to a home equity loan, don’t forget that you need to be very sure you can meet your repayments because you are increasing your risk by increasing your loan amount, and if you default on your loan, you risk losing your home. Therefore, look carefully at your budget to make sure you can afford the higher repayments, and that you can afford them if interest rates were to rise. Also make sure you have a plan and an emergency fund to cover repayments if you were to lose your job, or were unable to work.
Also make sure that when you are looking for home equity loans that you deal with a reputable lender. You don’t have to stay with your current lender, but be aware that there are many scammers out there who will try to confuse you with a high pressure sales pitch, yet won’t put anything in writing and you can end up losing your home.
Differences Between a Home Equity Loan and a Line of Credit
There are two main ways you can access your equity, through a home equity loan or through a home equity line of credit loan.
A home equity loan:
- Pays out your equity in a lump sum amount and that amount is immediately added to your principle loan amount.
- Is suited to once off purchase such as an investment property or a holiday.
- Is suited to long term purchases such as renovations.
- Allows you to choose a fixed or a variable interest rate.
- Requires principle and interest repayments.
A home equity line of credit:
- Has a revolving balance which you can draw down on, pay off and draw down again.
- Is suited to recurring expenses such as a staged home renovation or education expenses.
- Has a draw period during which you can use the equity amount, and a repayment period, during which you must pay back the amount.
- You are only paying interest on the amount of equity you have drawn down.
- You can draw down on the equity amount whenever you need it, so you are not tempted with a lump sum of money.
- You may be tempted by the available line of credit which acts just like a credit card balance.
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