How Does Equity Work When Buying a House?
When you start out on your home buying journey, one term you’ll likely hear time and time again is “equity”. But what exactly does this mean and how does it work? Below, you’ll find everything you need to know laid out in an easy-to-understand way.
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We’ll break down the concept of equity, how it accumulates, and how it can be used, making it possible for you to make an informed decision ahead of purchasing a property and manage your finances more effectively.
What is Home Equity?
The simplest way of explaining what home equity is, is to say that it refers to the difference between the current market value of your property and the amount you owe on your mortgage. This means that it is the portion of your that you truly own.
For instance, if your house is worth $800,000 and you owe $500,000 on your mortgage, your equity is $300,000.
You build equity in your home over time as you pay down your mortgage and as your property increases in value. This growth can be a powerful financial tool, as it offers opportunities for further investment, renovation, or even funding significant life events.
How Does Equity Accumulate?
There are a few different ways equity accumulates in your home, including:
Mortgage Repayments
With each mortgage payment you make, a portion goes towards the interest, and a portion goes towards the principal, meaning that you gradually reduce the principal amount you owe on your loan. As such, as the principal reduces over time, the equity in your home increases.
Property Appreciation
The real estate market can significantly influence the value of your property, and if property values in your area rise, the market value of your home increases. As a result, the equity in your home increases. It is worth noting, however, that this can be a double-edged sword, as if property values decline, your equity may also decrease.
Home Improvements
Investing in home improvements can add to your property’s current market value, boosting your equity in the process. This can include renovations like updating the kitchen, adding an extra bathroom, or landscaping, each of which has the potential to increase property value.
Using Existing Home Equity in Other Ways
Home equity isn’t just a static figure; it’s an asset that you can leverage for various financial opportunities. Here’s how you can use your home equity effectively:
A Home Equity Loan
Put simply, a home equity loan allows you to borrow against the equity in your home. This is typically a lump sum loan with a fixed rate, which you repay over a set period, and it can be an excellent option for large expenses such as home renovations or debt consolidation. However, before committing to this, it’s highly recommended you seek the advise of a mortgage broker.
It is important to note that total equity in the house is not the same as how much of that equity you could potentially access. Most lenders will only allow you to access 80% of the property’s total value as a loan before you have to pay LMI.
For example:
- Your home is valued at $1,000,000
- Your current home loan is $200,000
In this scenario, your total equity in the home is $800,000, however, the bank will only allow you to borrow 80% of the property value with no LMI, so your total borrowable equity in that instance is $600,000 ($800,000 being 80% of the property value, less your current $200,000 home loan).
Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) is a more flexible option compared to a home equity loan. The simplest way to think of a HELOC is like a credit card, providing a revolving line of credit that you can draw from as needed. The interest rates on HELOCs are usually variable, and you only pay interest on the amount you borrow, which can be particularly useful for ongoing expenses or projects.
Refinancing Your Mortgage
Refinancing involves replacing your existing mortgage with a new one, typically with better terms. If you’ve built significant equity in your home over time, you might be able to refinance for a larger amount than what you currently owe, effectively cashing out a portion of your equity, which can be used for various purposes, including purchasing investment property or paying off high-interest debts. Get more information on refinancing your home loan here.
Property Investment
Another way of using your home equity is by purchasing an investment property. This is often referred to as “equity release”, and it basically involves leveraging the equity in your existing property to secure a loan for a new property, which can then be used to generate rental income and further grow your wealth. Learn more about investment property loans here.
Risks and Considerations
While leveraging home equity can be beneficial in many ways, it also comes with risks and considerations that you need to be aware of. Let’s explore some of these in more detail.
Increased Debt
Using equity means increasing your overall debt, so it’s essential that you’re able to manage the additional repayments without straining your finances. Beware of over-leveraging also, as this can lead to financial difficulties, especially if the property market fluctuates of your personal circumstances change.
Interest Rates
The interest rate on home equity loans and HELOCs can vary, and while they are often lower than most other types of home loan, they can still fluctuate. As such, it’s important to consider how changes in interest rates might affect your repayments over time.
Property Market Volatility
The real estate market can be unpredictable, and a downturn could reduce your home’s value, decreasing your equity in the process. This is a significant risk if you’ve leveraged a substantial portion of your equity, as it could lead to negative equity, which means you may end up owing more than your property is worth.
Long-Term Financial Goals
Using your home equity should align with your long-term financial goals, so it’s important to consider whether leveraging equity for immediate needs might impact your future financial stability and retirement plans.
Building Equity Strategically
Building home equity isn’t just about paying off your mortgage. With strategic planning and smart financial decisions, you may be able to build equity more effectively and at a faster rate. Here are a few things you can do:
Make Extra Repayments
By making extra repayments on your mortgage, you may be able to significantly reduce the principal amount faster and increase your equity sooner. Even small additional payments can have a substantial impact over time, so it’s definitely something worth considering if you can afford to do so.
Opt for a Shorter Loan Term
Similarly, choosing a shorter loan term means higher monthly repayments but can help you build equity faster. This is simply because the sooner you can pay off your mortgage, the sooner you own more of your home and the equity that comes with it.
Invest in Property Improvements
Strategic home improvements can increase your property’s value, and by focusing on renovations that provide a good return on investment, the higher your equity will be.
How a Mortgage Broker Can Help Navigate the Intricacies of Home Equity
Working out the complexities of home equity can be challenging, especially when you’re trying to maximise its potential while managing risks. This is where SimpliFi Lending can help, and we can assist you in the following ways:
Mortgage and Equity Advice
We’re able to offer you expert advice on mortgage options and home equity products that best suit your needs. Whether you’re considering a home equity loan, a HELOC, or refinancing, we’ll guide you through the advantages and disadvantages of each and help you understand the terms and conditions, interest rate, and repayment structure.
Investment Advice
If you’re considering using your home equity to purchase an investment property, we can develop a strategy for you that aligns with your financial goals and provide insight into the real estate market, helping you understand the potential returns and risks involved.
Risk Management
Leveraging home equity involves risks, including market volatility and interest rate fluctuations. At SimpliFi Lending, our team can help you manage these risks by advising on the appropriate level of debt to take on. We can also recommend strategies to protect your assets and ensure you have a contingency plan in place for any unexpected financial challenges.
Contact Simplifi Lending Today!
When you’re ready to start learning more about using the equity in your property, contact Simplifi Lending for a no-obligation chat. We’ll listen to your objectives, offer expert advice on the best way forward, and give you peace of mind that you’re in the best possible hands.
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