How home owners can put their equity to work

Equity is the difference between the value of a property and the balance of the home loan. For example, a home owner with a $500,000 property and a $400,000 home loan has $100,000 in equity.

If the home’s value increases to $600,000 and the loan balance remains the same, the owner has $200,000 in equity.

Paying down the principal, property improvements and a rising local market can accelerate the rate at which equity accumulates.

“One of the things people underrate is what a difference it makes,” says Canstar’s Steve Mickenbecker.

“A $500,000 property going to $600,000 is about three or four years in the property market in most capital cities. It enables you to buy another property in three or four years.”

While selling a property unlocks equity, home owners who retain their property can access equity by refinancing, increasing the size of their loan, or taking on a secondary loan.

How much equity home owners access?

Lenders usually don’t allow home owners  to borrow the full value of their home, meaning not all the equity can be accessed.

“For the right purpose and the right loan amounts, you can go up to 85 or 90 per cent,” says mortgage broker and Foster Ramsay Finance director Chris Foster-Ramsay. “I wouldn’t recommend accessing equity above 70 per cent of the property’s value.”

A lower loan-to-value ratio reduces the risk of overextending if circumstances change, and protects against rate changes and the possibility of negative equity should the value of the home fall.

Accessing equity means taking on more debt, causing repayments to rise. Before accessing equity, it’s crucial that home owners ensure they can manage the increased repayments with their household cash flow, ongoing expenses and lifestyle.

“The amount of money available for equity is secondary to the ability for that person to borrow the money,” Foster-Ramsay says.

What can equity be used for?

Home owners can use equity to help purchase an investment property, fund a renovation of their own home, or even pay for a new car, boat, holiday or wedding.

“Vehicle purchases, renovations or deposits for different properties are the most common,” Foster-Ramsay says. “Lenders don’t like releasing money without any justification. During the pandemic, holidays — given the borders are closed — and weddings have been harder to justify, but that will go back to normal.”

Buying a car using equity has become less common, Foster-Ramsay says. “The royal commission pointed out that it’s pointless to borrow for a car over a 30-year term when there’s no way the asset will last 30 years.

“Lenders have updated their policies around vehicle purchases and pleasure craft to no more than 10 years, which would make it on par in most cases to the dealership finance.”

Finance for renovations is usually restricted to small-scale cosmetic changes up to about $80,000 in value, according to Foster-Ramsay.

“You can’t be moving external walls or changing the footprint of a home on the exterior, but in the interior you can apply those funds.”

Larger structural renovations usually require a construction loan, where funds are drawn down at key stages of the construction process.

How to use equity to purchase another property

One strategy to build a property portfolio through property relies on equity. Owners can leverage the growth in value of their own home to purchase another property, potentially repeating the process as the value of the next property rises.

“We see a lot of surprised looks where we present a loan structure where the equity of the property they’re living in can support, in some way at a very high level, the deposit for an investment,” Foster-Ramsay says.

By accessing equity to use as a deposit, home owners may be able to invest without contributing cash from savings. The balance of the purchase is funded with an investment loan, with rent covering or potentially exceeding repayments, creating passive income.

This strategy typically relies on property values rising, which is never guaranteed, and plans can be derailed if values fall.

“More debt always comes with more risk,” Mickenbecker says. “You need to be comfortable with what you’re taking on.”