What to consider before using equity in your property

The concept of equity is confusing at times for many property owners as there are two ways to look at equity. One being from lenders point of view and the other being how owners look at it.

If you bought property in the last decade or even in the last 12 months, as long as you bought in the right location, over time passed, your property should have experienced significant value increase and in-turn your equity in that property also increased.

For the owner, the difference in the current value of the property and the current outstanding loan amount is their equity. This amount includes their deposit, any capital gains their property may have experienced and whatever loan principle they have paid down.

The lender on the hand, views equity as what’s useable for additional lending purposes and this equates to only 80% of the property’s value for borrowers not willing to pay lenders mortgage insurance (LMI) and those who are willing to pay LMI, 90% of the property value.

Use of home equity, whether for investment in a new property or improvements to the existing home, is a common wealth-creation strategy for many owners. It allows you to tap into the rising value of your home over time, without needing to use any cash savings.

There are, of course, risks to every investment. Here are four things you need to think about before using your home equity.

1. Maintain 20% equity buffer

Equity is the part you own in your property, it’s the difference between your property value and what the balance of your mortgage. Another way to look at it, it’s your wealth locked in that asset.

When looking to use your equity to buy another property or invest in shares, by sticking to 80% property to loan ratio, you will avoid paying LMI and have a buffer to cover for any ‘what if’ scenarios.

2. Invest wisely

Just because the equity is available, that doesn’t mean it should be used for just anything, avoid using it to consolidate personal or credit card debt.

Using home equity involves an increase in debt that will need to be repaid – so if your current income doesn’t cover the total repayment, the new investment needs to bring in a new revenue stream, such as a long-term tenant. 

3. Borrow within your means

At some stage, all the loans have to be paid back, even if it’s a lump sum with the resale of the investment asset – hopefully including a significant capital gain.

But between the purchase and conclusion of each loan, at least interest (but more often principal as well) will be payable, albeit at the more favourable rate of a home loan.

Consider this situation as you did when you first took out your original mortgage: balancing your income against a sensible repayment plan. If they don’t match, it might be wise to wait a little longer before dipping into your equity.

Check how your home loan compares

4. Good times do come to end

That process requires an extra level of conservativeness with a home equity loan. Test your plan against the possibility of interest rate rises, but also consider the chances of a fall in property prices. 

This can happen. Be prepared for this extreme, and you’ll be well placed to weather any other type of storm that arises. Failing to plan for the possibility could lead you to pay the ultimate price – a foreclosure of your home.

Home equity is a valuable resource for all property owners and can be used to start a wealth-generating property portfolio that will set you up for life.

But it’s not free money. As with any loan, owners need to carefully weigh up the potential risks against the rewards on offer.

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This article does not constitute advice; readers should seek independent and personalised counsel from a trusted adviser that specialises in property, a tax accountant and property design specialist.