What is home equity and why does it matter?

23/09/2020
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Home equity could help you into a new home, grow your investment portfolio, fund renovations and construction or even go on holiday. But what is home equity, and how do you actually unlock it? Our guide breaks down what you need to know.

 

WHAT IS HOME EQUITY?

Home equity is the difference between how much a property is worth, and how much is still owing on the principal of the loan.

Example:

You own a property worth $500,000.

You have $100,000 owing on the mortgage.

Your equity is $500,000 minus $100,000, which is $400,000.

 

Important: The value of a home is market value i.e. the value of the home were it sold at the time of the valuation. Different lenders use different valuation systems, so the specific amount of your equity may vary accordingly.

 

HOW DO YOU BUILD HOME EQUITY?

Home equity can typically be increased in two ways:

  • Increasing the value of the home
  • Decreasing the amount owed on the home

 

Increasing the value of the home

Two common sources of home value increases are:

  • Capital gains from increase in market values
  • Home improvements and renovations

Properties in New Zealand have historically increased in value over time. This, in turn, has increased equity for many homeowners. This increase in value is known as capital gains.

Some home improvements and renovations may also increase the value of a home.

Home values can also decrease as well as increase.

 

Decreasing the amount owed on the home

Equity can also be increased from the other end by paying down the principal of the initial home loan.

This is done naturally with every principal-and-interest payment made on a typical loan, but the amount owing could be further decreased through:

  • One-off lump sum payments.
  • Increasing payment amounts over and above those required.
  • Increasing payment frequency.

 

Increasing equity both ways

If someone has a typical principal-and-interest home loan and their home increases in value, their equity increases from both value increases and debt repayment.

This can result in significant gains in equity.

Example:

10 years ago, you bought a home worth $500,000 with a $100,000 deposit and a $400,000 home loan. Your equity is $100,000.

Over those 10 years, your property value doubled, and you paid $100,000 from the principal of your loan.

You now own a home worth $1,000,000 with a $300,000 home loan. Your equity is now $700,000.

 

HOW IS HOME EQUITY USED?

That sounds great, but how does home equity actually affect you? Home equity can be used in several ways, depending on your situation.

 

Getting a first home loan

Your initial deposit is your first ‘seed’ of equity. You have to fulfil the other credit criteria (such as showing you can service the loan), but the higher your deposit, the more equity you’ll have. This may make your loan application stronger.

Example:

You want to buy a property worth $500,000.

You have $200,000 in cash as a deposit.

You go to a lender and ask for a $300,000 home loan to make up the difference.

Your application is accepted, and you purchase the home. It is worth $500,000 and you owe $300,000, giving you equity of $200,000. This is the same as your initial deposit.

 

Buying your next home

If you’re already a homeowner and you want to buy a new house and sell your old one, your equity represents how much cash you’ll unlock when you sell your old home.

Once unlocked, this cash can be used as a deposit on a new home.

Example:

You own a property worth $500,000 and $100,000 owing on the mortgage, giving you equity of $400,000.

You sell this home for $500,000, using $100,000 of the proceeds to pay off what you still owe and close the mortgage. You now have $400,000 in cash.

You want to buy a new home worth $800,000.

You go to a lender and apply for a $400,000 home loan, using the $400,000 you unlocked from equity as a deposit. Your application is accepted and you purchase the home.

It is worth $800,000 and you owe $400,000 on your new home loan, giving you equity of $400,000. This is the same as your initial deposit.

 

Retiring

If someone is downsizing or buying a cheaper home after selling their old one, there may be some cash left over. This could be used to fund a retirement or to unlock cash for other uses.

Example:

You own a property worth $500,000 with $100,000 owing on the mortgage, giving you equity of $400,000.

You sell this home for $500,000, using $100,000 of it to pay off what you still owe and closing the mortgage. You now have $400,000 in cash.

You want to buy a new home worth $300,000.

You do so without needing to take a loan, paying cash, and leaving $100,000 in cash left over after the property purchase.

Home equity also comes into play when using equity release loans.

 

Unlocking cash

If a home is sold, the equity is unlocked as cash for use for other reasons, including moving overseas, going on holiday, investing elsewhere, and more.

Example:

You own a property worth $500,000 with $100,000 owing on the mortgage, giving you equity of $400,000.

You sell this property for $500,000, using $100,000 of the proceeds to pay off what remains of your mortgage.

You now have $400,000 in cash.

You also don’t have to sell the home to unlock equity as cash. This is sometimes called a mortgage top up, a re-draw or equity release loan.

 

Property investment

Home equity doesn’t always have to be converted to cash in order to be used. Property investors can use their equity in an existing property as a deposit for a new one.

This means they keep ownership of their existing home. This is known as a cross collateralisation.

Example:

You own a property worth $500,000 and $100,000 owing on the mortgage, giving you equity of $400,000.

You want to buy another property worth $300,000 as an investment.

You approach a lender and apply for a $300,000 investment home loan. You offer your existing home as security.

The lender sees that you have $400,000 in equity in your first home and accepts your application after checking you meet other credit criteria.

You use the $300,000 home loan to purchase the investment property.

You now own two properties worth $800,000 total and owing $400,000 on your original home. Your equity remains at $400,000 across your new portfolio.

This is just one example of several investment property loan products that may be available to investors.

 

Construction or renovation

Home equity can be used to fund the construction of a new home or the renovation of an existing one.

Example:

You own a property worth $500,000 and $100,000 owing on the mortgage, giving you equity of $400,000.

You want to do renovations on your property that would cost $50,000.

You approach a lender for a loan, offering your existing property as security.

The lender sees that you have strong equity and accepts your application after checking you meet other credit criteria.

You use the $50,000 loan to fund renovations.

You now own a property worth $500,000 and owe $100,000 plus an additional $50,000 from your second loan. Your equity is now $350,000, having been reduced by the value of your second loan.

This may also be available as a line of credit.

 

HOW DO YOU UNLOCK HOME EQUITY?

Homeowners who have bought in a good area and have paid down their debt may now be realising that they have a lot of equity that they want to put to work!

Typically, equity can be unlocked in two ways:

1. Selling the home - any surplus equity left over after settling any debts on the property becomes cash in hand.

2. Working with a lender to get a loan that releases equity.

There are many options for home loans that release equity available in the market, all structured differently for different uses and different credit situations. Get professional advice and several options before you make a decision.

 

If you’ve been growing your nest egg and want to unlock equity from your home or property portfolio, discover your options in a home loan from Avanti Finance now.

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