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What are the rules of a home equity loan?
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This article is over two years old, last updated on July 26, 2022. While RateCity makes best efforts to update every important article regularly, the information in this piece may not be as relevant as it once was. Alternatively, please consider checking recent home loans articles.
Accessing your equity can help you make the value of your property work for you, allowing you to enjoy more financial flexibility and reach your goals. But there may be rules and regulations to consider before applying for a home equity loan, which could affect your decisions.
What is equity?
The equity in your home is the current value of your property, minus the remaining mortgage principal. Borrowers can increase their equity in their property by making principal and interest mortgage repayments, as well as extra repayments, to help shrink the outstanding mortgage principal. Also, if property values in the area increase over time, this can also grow the equity in your property.
Imagine buying a property for $500,000 by paying a 20% deposit of $100,000 and taking out a $400,000 home loan. This would give you $100,000 in equity to start with.
After several years of making principal and interest repayments as well as extra repayments, you’ve paid back $100,000 of your $400,000 loan, reducing the remaining principal to $300,000.
At the same time, values increase in the area where your property is located – a free property report tells you that your property may now be worth $600,000.
This would mean that the current value of your property ($600,000) minus the remaining mortgage principal ($300,000) gives you your current equity of $300,000.
What is a home equity loan?
A home equity loan is where you use the equity in your property as security to borrow money. This could mean borrowing a lump sum (including refinancing your current loan or taking out a mortgage on another property) to be repaid in instalments over time, or accessing a line of credit, where you can borrow up to a pre-set credit limit with flexible repayments.
One type of home equity loan is a reverse mortgage, which is most often used by retired Australians who own their home. A reverse mortgage allows you to borrow against the value of your home, with repayments usually not required until you go into aged care, sell your home, or pass away.
Home equity loans are available from a variety of banks and mortgage lenders. Reverse mortgages may also be available from these lenders, or there’s a government option from Services Australia – the Home Equity Access Scheme.
What is required for a home equity loan?
In most cases, you may not be able to access all of your home equity using a home equity loan. This is because your mortgage lender will usually require at least 20 per cent of your home’s value to be unencumbered by a mortgage, to help reduce their financial risk in the event you default on your repayments. Your usable equity will typically be 80 per cent of you home’s value minus the outstanding mortgage principal.
Following on the earlier example, imagine holding a mortgage over a property now valued at $600,000 with $300,000 owing on the mortgage. To fulfil your lender’s 80% LVR requirement, you’ll need to hold at least 20 per cent equity in the property.
To find your usable equity, eighty per cent of your property value ($480,000) minus your remaining mortgage principal ($300,000) gives you a usable equity of $180,000.
Similarly to applying for other loans, finance or credit products, the lender may also want to know about your income, expenses and credit score to make sure you can comfortably afford the home equity loan, and are unlikely to end up in more debt than you can comfortably afford to pay back. There may also be other requirements, such as having adequate home insurance over the property.
Additionally, a valuation will likely be required to confirm the value of your property and calculate your exact equity amount. This may require paying for a professional valuer’s assessment, which may not always match the estimate from a free property report.
Reverse mortgages may work similarly to other home equity loans, though there may be some extra rules and regulations to consider. For example, you may need to completely own your home outright, and be eligible to receive a pension before you can apply. The income you access from a reverse mortgage could also potentially affect the pension you receive, and could also have tax implications.
Different mortgage lenders may have different terms and conditions on their home equity loans, so it’s important to read the fine print and consider talking to an expert before you apply.
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