How do you borrow against home equity for a home loan?

Ever heard the term ‘asset-rich but cash-poor’?

Just before most people buy their first home, they’re cashed up with a hard-earned deposit, trying to procure an asset. After they’ve settled, however, the cash is often all funneled into that asset, and for many of us, anything extra they have lying around is also invested into paying off that mortgage.

If this sounds like your situation and you find yourself needing access to extra funds – be it for an investment property, a big-ticket renovation or a holiday – then using the equity in your home to get a loan might be an option, particularly if you’ve owned the home for some time.

Your home equity is the difference between the amount you owe on your home loan, and the amount your home is worth. As a basic example, if you have $500,000 remaining on your mortgage, and your home is worth $1.2 million, the equity in your home is $700,000. The value is held within your asset, rather than as savings in a bank. As a result, many lenders will allow you to borrow against this a portion of this amount, effectively using your major investment – your home – as security to access cash you might not otherwise be able to.

There is a range of different loan products that can be secured against the equity in your home – for example, you might use the equity in your home to secure a line of credit, or you might use it in place of a deposit for an investment property loan.

There are a few different equations at play when it comes to figuring out how much you can borrow against your home’s equity. The first step is to determine how much your property is worth in the current market – you can get an estimate based on recent comparable sales in your area, or you can ask an appraiser to come and value your home.

Once you know the value of your home, deduct the amount you owe on your mortgage, and any other loans that are secured by the property. For example, you may have an existing line of credit, such as a credit card or personal loan, with money owing in addition to the amount left on your mortgage, and both of these would need to be deducted from the property value.

The remaining amount is your equity, but there is an extra step required here: most lenders will usually calculate your accessible equity as 80 per cent of your home’s value minus your remaining debt. This gives them and you a reasonable buffer.

The equity in your home tends to increase over time with both the value of the home (as long as house prices rise over time) as well as with continual funds being repaid. One of the major benefits of being able to access a loan against home equity is for investors – because it can allow some property investors to build their property portfolio without the need for another deposit – which can take years. This way, an investor can purchase an additional property (subject to being able to service the new and existing loan) without having to wait on saving a substantial deposit.

Another benefit in using your home’s equity to access loan funds is that they could be used for home renovations. If these funds are used for home improvement, it may even help to increase the value of your home, and potentially increasing the home equity along the way. If the funds are required elsewhere, using equity to finance a big-ticket item may allow you to access lower interest rates and better payment terms than some other loan products, because a loan on equity is typically secured by the property itself.

No financial decision is without its risks, and home equity loans are no different. One of the risks is that digging into your equity leaves less in reserve, meaning you are more exposed to housing market fluctuations and changes in interest rates. In addition, if you invest using equity and register a loss, that loss can be compounded by having to pay interest on the funds used in the first place. Larger repayments can also be risky, particularly when your home is the security behind the loan.

A traditional mortgage typically requires a deposit from the purchaser in order to provide collateral for the loan, whereas a home equity loan takes into account existing equity in place of cash. Depending on how much equity you have access to and your financial situation, you may be able to use the entirety of your home’s accessible equity to secure a loan on an investment property, for example. When used in place of a personal loan (for example, to fund renovations, a holiday or a car purchase) home equity loans usually offer longer repayment terms and lower interest rates. It’s important to note however that because the repayment terms are longer, if you don’t pay the amount down quickly, you may end up paying significantly more in interest over the course of your loan.

If you’re considering using your home equity, for an investment, home renovations or for another reason, it’s important to have all the information you need to make a decision suitable for your circumstances. It’s recommended to speak with a financial professional, such as a financial advisor, who could help you better understand your options and any associated risks.