Everything You Need to Know about Using Home Equity for a Deposit

Home equity can be powerful for unlocking the value of your home and as a deposit to purchase another property, such as an investment property. While using equity in your home offers benefits, it’s also important to consider the potential shortcomings and alternatives.

If you are curious about how equity works or considering a home equity loan, here’s an overview to help you weigh the pros and cons.

What is home equity?

If you’re unfamiliar with the term, here’s a quick explanation. Simply put, the equity of your home is the current value minus what you owe on the mortgage.

Let’s say you purchased your home 5 years ago for $700,000. You paid a 20% deposit of $140,000 and took out a mortgage for $560,000. You’ve been making repayments on your mortgage for 5 years, and you now owe $470,000 on the mortgage. At the same time, the market value of your home has increased to $800,000. Given that the equity is the value of your home minus what you owe on your home, the equity in this situation is:

$800,000 – $470,000 = $330,000

So now, the home equity is $330,000. But it will change as the property’s market value goes up or down, and as more repayments are made.

The term negative equity is the unfortunate circumstance where the value of the property decreases to the point where you owe more than the property’s value. This is sometimes called an underwater or upside-down mortgage. To avoid this situation, lenders will only lend a portion of the property’s value, which is called the loan-to-value ratio, or LVR. Typically, this value is 80%, as in our example above. This means that the equity available (called usable equity) in our example is $264,000 ($330,000 x 0.80).

Given that the amount of equity in your home is determined by the market value, lenders want to ensure that this figure is accurate. For this reason, lenders will often require a professional property valuation before making any lending decisions.

Using home equity as a home loan deposit

You can use the equity in your home as a deposit for an investment loan. This is sometimes called ‘home equity release’. You typically need a 20% deposit for a home loan. So based on the example above, where we had $264,000 in usable equity, you could potentially purchase a property for $1,320,000 (0.2 x $1,320,000 = $264,000). Other factors will be taken into account when approving a loan – including your credit history and your perceived ability to make repayments.

You can also leverage home equity for other financial products.

One of these is a line of credit, which is based on the equity available. With a line of credit, you only pay interest on the amount you’ve spent (drawn down). With these types of loans, you can make lump sum repayments and redraw funds if needed. Sometimes home equity lines of credit are used for renovations.

With a deposit bond, you can use equity for a deposit bond or guarantee instead of using it for a cash deposit. This type of product is often used for buying off-the-plan with a 1 to 2-year settlement. While awaiting settlement, a deposit bond generates interest.

Consider the pros and cons of accessing home equity for a deposit

On the positive side, the equity in your home can be used to get a better interest rate and avoid having to purchase lenders’ mortgage insurance (LMI) if you want to pay a deposit lower than 20%. LMI is around 1% to 2% of the loan value, so it will add to costs.

At the same time, the property from which you are taking equity will be used as additional security for the new loan. When you use more than one property to secure a loan it’s called cross-collateralisation. This has some potential drawbacks including the loss of flexibility when making investment decisions, more expense and paperwork when you buy and sell, lack of access to all loan products and features if you’re with one bank.

 

Whatever you decide to do, it’s a good idea not to use all the available equity in your home as a deposit for an investment property. Having a buffer set aside can help you meet any emergencies that might arise.

Get professional advice when using home equity for a deposit

With all the options available, it can be confusing when choosing to use home equity for a deposit. The experts at Reduce Home Loans can guide you through the process. We listen to you and carefully consider your situation and goals to offer solutions to your property finance needs.

 

Contact a lending professional at Reduce Home Loans to get started.

 

Any statements are general in nature and do not take into account your financial personal situation, objectives or needs. You should consider whether any statement/s is suitable for you and your personal circumstances. Before making any financial decision, consider your circumstances and the product disclosure statement.

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