The Australian home loan market is a vastly different place than it was a few decades ago.
Today, there are a number of home loan products on the market designed to suit a range of financial circumstances.
One of the these products is a home equity loan, which is a credit facility that taps into the existing equity in your property.
A home equity loan is a type of loan in which the borrower uses the equity of his or her home as collateral.
The loan amount is determined by the value of the property, which is usually determined by a recent valuation.
The types of home equity loans
The most common type of home equity loan (also called a line of credit loan or LOC for short) available is one that provides a loan amount (based on a property valuation and also considering the maximum loan-to-value ratio of that particular lender), ogether with a variable interest rate, that can be used for any purpose whatsoever.
Generally, a home equity loan will be provided to borrowers who not only have equity in their property but also have shown financial discipline, which often means someone who has a solid credit history and a stable income.
The funds are like a revolving line of credit, based on the equity available and any lender LVR limitations.
The borrower has the ability to use the money whenever is necessary and is only charged interest on the proportion that’s used.
When are Home Equity Loans useful?
Home equity loans are a useful financial tool – as long as you have the discipline to repay what you withdraw, plus interest, and don’t use the funds frivolously on impulse purchases like a new jet-ski in summer-time.
For homeowners and property investors keen to improve their overall financial position, home equity loans can provide the funds they need when they need them the most.
Home equity loans should generally be used for major expenses that will ultimately improve your property’s value or increase your portfolio.
Cosmetic and structural renovations are often financed via a home equity loan or LOC, which can result in a higher valuation of the property once the project is completed.
For example, Sally has a $200,000 line of credit facility and uses $50,000 of it to finance a renovation of her home.
The LOC funds available have reduced to $150,000, but she only pays interest on the $50,000 she has spent.
Sally then organises a new valuation of her property, which has increased by $100,000 post-reno, which means that her LOC could also increase if she so wished.
Many investors use a home equity loan to buy another investment property as the funds available can be used for the deposit with the balance financed by a standard home loan.
Another regular use for this type of loan is the consolidation of high-interest debts.
For example, perhaps you have a smallish car loan and credit card debt that you’ve been paying off.
You could use a LOC facility to pay off both debts, which attracts a lower interest rate than personal loans and credit cards.
Of course, you need to have the discipline to not load your credit card up again with bad debt or take out personal loans for non-appreciating assets.
The benefits of home equity loans
One of the main advantages of a home equity loan or LOC 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.
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.
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.
You need to spend money to make money when investing in property but the idea is to access funds you weren’t even aware of, namely the equity in your existing property.
And that’s where a home equity loan or LOC comes into play because you can use money that you usually couldn’t access to grow your investment portfolio quicker.
Other advantages of home equity loans or LOCs are their very flexibility, meaning that the funds are readily available for whenever you need them.
You don’t have to apply to anyone to unlock them or jump through any further financial hoops.
The money is already there and you don’t have to ask anyone – but your own conscience perhaps – how you’re going to spend it.
Of course, that’s where discipline comes into the equation, too.
The Risks of Home Equity Loans
As we’ve already mentioned, home equity loans are not without their risks, that’s why these types of loans should only be considered if you have enough willpower to prevent overspending.
Having a vast pool of money – sometimes in the hundreds of thousands of dollars – which you can take advantage of whenever you like, on whatever you like, is a temptation for anybody.
One of the main risks with a home equity loan is for people who perhaps have a pattern of overspending who then “double-dip” by accessing funds from their LOC to pay down debt only to rack up more debt by continuing to spend more than they earn.
This type of debt cycle usually never ends well so you must be the type of person with the necessary restraint not to consider the equity funds as “free money” because it’s not.
The money you spend reduces the total equity in your property until such as a time as you pay it back or the valuation of your property increases.
Other risks associated with home equity loans include the higher interest rates that are charged as well as the potential to overcapitalise on renovations because you might think that a budget doesn’t really matter when you have “ample” funds available.
To reduce the risks that can be associated with home equity loans, you must firstly consider whether you have the required financial discipline to use this facility responsibly.
If renovating, you should also always have a budget that outlines the likely total costs and stick to it.
You must also remember that the end game of renovations or home improvements should be to increase the value of the property, which means you have to control your spending on the project to achieve the very best bang for your buck.
*The information provided in this article is general in nature and does not constitute personal financial advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information with regard to your objectives, financial situation and needs.