Are you looking to purchase a second property? If so, a home equity loan may be a good way to go.
What is home equity?
The equity in your home is the current value of your property, minus the remaining mortgage principal. Home equity is increased by making principal and interest mortgage repayments (including extra repayments) to help reduce the outstanding mortgage principal.
Your home equity can also grow if the property values in your area grow.
Example
Let’s say you purchase a property for $700,000 by paying a 20 per cent deposit of $140,000 and taking out a $560,000 loan. This gives you $140,000 in equity to begin with.
After several years of making principal and interest repayments, as well as making additional repayments, you have paid back $140,000 of your $560,000 loan, reducing the principal to $420,000.
At the same time, the value of properties in your area has increased, and your property may now be worth $800,000.
The current value of your property minus the remaining mortgage principal means your current equity is $380,000.
How does home equity work?
A home equity loan is part of your available equity as security to borrow money, either as a lump sum to repay over time or as a line of credit that allows you to borrow and repay money up to a pre-set limit.
How can home equity be used to buy a second home?
There are a few ways you can use the equity of your current home to buy a second property, let’s go through them.
Second home loan
Most lenders will require you to keep 20 per cent of the equity in your property to reduce their financial risk, in the event you default on your repayments. You may be able to borrow a higher amount with some lenders, but you’ll need to pay Lender’s Mortgage Insurance (LMI). If you don’t want to pay LMI, the loan amount must be less than 80 per cent of the property value.
Line of credit loan
Line of credit loans let you access a set level of credit based on your home equity. You can use funds up to this set level and interest is only charged on the amount you use.
The maximum limit for a line of credit may be based on your available usable equity; however, some lenders may set caps on credit limits, even if you have more usable equity available.
Reverse mortgage
A reverse mortgage is a home equity loan that doesn’t require borrowers to make repayments while they still live in the home. Instead, the interest compounds over time, and borrowers only have to repay the balance in full when they either sell the property or pass away.
While reverse mortgages work like other home equity loans, they typically come with some additional rules and regulations. For example, you may need to completely own your home outright and be of pension age, as reverse mortgages tend to be geared towards older Australians who are ‘asset rich but cash poor’.
It is important to understand the income you access from a reverse mortgage could affect your pension and have tax implications.
Cross-collateralisation
This option only applies if you plan on buying another property for investment purposes.
Cross-collateralisation is using your current property as collateral and adding it to a new investment home loan. This means you’ll have two home loans to repay (the original home loan and a new home loan that is secured by the existing property and the investment property). This can be considered high-risk because if you can’t service the debt on one of the loans, you could lose more than just that one property. So make sure to consider this option carefully.
Things to consider
You’ll need to make sure that the current equity in your home and your future income are adequate to ensure you’ll be able to pay both loans comfortably and on time. This is something that the lenders will have to be convinced with, to give you the green light.
To make their assessment, lenders will look at your income, expenses and credit score to make sure you can afford the home equity loan. There may also be other requirements, such as having adequate home insurance over the property.
What if you don’t want another loan?
You can use the loan you already have – discover options below:
Refinancing
If you want to use your home equity to fund another property, but don’t want to take out a loan, you could consider refinancing your current mortgage. You can increase the amount you’re currently borrowing for a deposit on a second house.
Redraw facility
If your mortgage has a redraw facility and you have been making extra repayments, you should be able to take out money and put this towards a deposit on another property.