If you own a property, the difference in the amount you own on that property and its market value is known as equity. When people mention equity, you may be asking some questions like how does equity work in property? The main benefit is your ability to access this equity to secure further finance for things like maintenance and renovations or a deposit for your next home or investment property.
You may also use this equity to fund other wealth-building opportunities like a managed fund or shares.
Regardless of what you intend to use it for, your equity can be a valuable asset, and Urban.com.au have put together this guide to discuss precisely what is equity in property investment and the advantages and disadvantages of equity in property investment.
What is equity in property investment?
To understand how much equity you have in your property, your financial institution will require you to get a professional property valuation. You can estimate how much your property may be worth, but in regards to securing finance, you’ll need to arrange an expert to give a definitive figure.
There are a number of factors that will determine if you can borrow additional funds to access your equity, including:
- Living expenses
- The remaining amount owing
- Lenders’ Mortgage Insurance (LMI)
- The property valuation
There may be other circumstances concerning your loan that may apply, and in some cases, you may only be able to access a certain percentage of your equity. It is vitally important to discuss all of this with a lender before making the decision to go ahead with accessing your equity to confirm that you are not overcommitting and risking financial hardship.
Building equity in your home
Based on the information above, it is clear that more equity is a good thing. It is a substantial factor that can significantly increase how much you can borrow for new property. You can build equity in your home to improve your financial position via a number of methods, including:
- Renovating your home to increase its value
- Making more repayments to reduce your loan balance
- Using a mortgage offset account in which your savings offset your loan balance, reducing the interest charged on your loan
- Tax deductions via increased interest charged (when using the equity for an investment property)
It is important, however, to remember that using any equity you may have in your property may increase the amount you owe, resulting in higher repayments. Some loans also have restrictions which prevent you from accessing equity and making additional repayments.
Advantages and disadvantages of equity in property investment
While the accessing of equity is something that many investors and homeowners do due to its advantages, there are also some risks involved that you will want to be aware of.
If you are looking to expand your property portfolio or even just renovate a current property, equity could help you to do it. This is where the ability to boost the equity in your property, as mentioned above, will offer you more options financially.
The advantages of using equity
- Lower interest rates
Accessing equity without having to sell the property means that the extra money you borrow sits at the low-interest rate of your mortgage, which is likely a lot less than getting a personal loan or credit.
- Extra funds
Equity boosts up your savings to help fund another property, shares and managed funds, or a renovation.
- Can raise the value of your home
If you are putting these new funds back into your home via a renovation, you can boost your property’s value. Just ensure that the amount you are investing in improvements actually increases the property’s value by the same amount, if not more.
The disadvantages of using equity
- Larger repayments
Using your equity will increase how much you owe and the interest charged. Ensure that you will still be able to afford your new repayments after accessing the equity as you don’t want to put yourself into financial hardship. Your lender will be able to inform you of your new repayment amount. If you are using these funds for something like an investment property, they may generate income which will help offset the higher repayments. In this situation, you will need to account for potential interest rate rises as you may be able to afford an increase in repayments now, but many people find themselves in financial stress if they are overburdened by a rate rise.
- More risk
Borrowing more to invest magnifies your risk. You are essentially investing money that you don’t have meaning it’s crucial for the investment to make a return. A loss is further compounded by the interest you are paying on the funds. Before making any moves like this, it is best to speak to a qualified accountant or financial planner to fully understand your risk profile.
- Excessive interest
The interest rate may be relatively low, however over a 25 or 30-year loan term you are paying thousands of dollars in interest. Accessing your equity will absolutely cost you far more in the long run if you leave the loan for its full term.
Things to be aware of
If you are considering a home equity loan, you’ll need to keep a few extra things in mind, on top of all of the above information, before making your final decision.
1. There must be enough equity in your home
You still need to have enough equity in your property to satisfy the bank. If your property is worth $400,000 and you borrow $400,000, selling the house for enough to pay the loan, inclusive of the extra costs involved in this process, may be difficult. The financial institution will look at your combined loan-to-value ratio, which is the amount of your original loan added to the new loan, divided by the total value of your home. If it doesn’t sit around 80% or less, your proposal may be knocked back.
2. Interest is tax-deductible
A benefit in most cases is the tax-deductibility of loan interest, which may save you thousands of dollars.
3. You may be charged a higher rate of interest on a home equity loan
In some cases, you may be charged a higher rate of interest than that of your standard loan; however, this will still likely be a lower interest rate than a personal loan or credit card.
4. It may be considered as a second mortgage
In the unfortunate event that your home is foreclosed and sold for less than owed on the two mortgages, the first mortgage would be paid in full, possibly leaving you with an amount due on the second. Tapping into your equity sometimes comes with a higher interest rate, and as mentioned earlier, higher risk.
The decision to use equity
The use of equity as part of a financial strategy to increase investments is not a new idea, and many investors do this regularly without any issues. However, it is essential to accurately assess your financial situation before making the decision to do this, as your risk levels will increase. There are many hidden costs associated with buying property, so you will need to ensure that all figures are accounted for when running your numbers.
Borrowing against your home may seem like a great way to knock off that credit card debt and lower your interest rate but taking too much equity out of your home and owing more than the property is worth, especially in the unfortunate event that your home loses value, can be a big problem. To avoid this, be sure that you can make the payments for the life of the loan and ensure that whatever it is you are borrowing for is worth it.
This article was republished with permission from urban.com.au.