Equity: What is it? What can it be used for? - Pearl Financial

Equity: What is it? What can it be used for?

By Shane | Investing

Nov 20

A scenario that comes up frequently for homeowners is that after purchasing a home, and after a period of time paying down the loan combined with capital growth of their property, they develop equity in their home. Many of these people want to know how best to use their equity.

What is equity?

In simple terms, equity is the difference between the market value of your property and the amount you still owe against your property. For example, a property is valued at $500,000. It currently has a loan against it of $300,000. So the equity would be $200,000.

Why would you access equity?

Below are some of the reasons why you would want to access your equity.

  • You may need to increase the size of your home or renovate the kitchen/bathroom etc. Today, home renovation often costs a lot and most people have not been able to save for it so they use their equity built up in their property to fund the renovation of their home.
  • You may wish to take the holiday of a lifetime. However, you do not have enough savings to pay for it so accessing equity is an option.
  • It may be time to upgrade a family car or purchase a major item for your home.
  • As part of your investment strategy, you may wish to take the equity and invest in shares, exchange traded funds, managed funds etc.
  • You may wish to purchase an investment property to help fund your retirement.

Using the equity in your home can help to create or build your wealth by accessing other investments, including property.

Undoubtedly, most people get confused in calculating how much equity they have, and what part of their equity they can access. Going back to the example, you have a property valued at $500,000 and you owe $300,000. You’d like to access equity in your property. If you access a $100,000 of equity, then you take a total borrowing of up to $400,000, which represents 80% of the total value of the property. In this scenario, you will avoid the need to pay any lenders mortgage insurance as your total borrowings don’t exceed the 80% loan to value ratio (also referred to as LVR).

You can potentially access more of your equity, however, that will take your total borrowings above the 80% mark and you will likely be required to take out lenders mortgage insurance, which can be very costly. But still, there are times that people do that generally because the return from the potential investment outweighs the lenders mortgage insurance costs.

The remaining equity can only be accessed when you sell the property. In the past, some lenders would allow you to borrow up to 100% of the value of your property. However, in the current climate, the majority of the lenders will keep your borrowings at 90% of the property’s value.

How do you access equity?

There are essentially two ways to access your equity. First is through a lump sum payout and the second is through a draw down or an equity facility. As a lump sum payout or draw down, you would increase your current loan or take an additional loan on top of your current loan. You will then have the funds deposited into an account or drawn in a form of a check payable to whoever the funds needed to be transferred to.

There are also instances wherein you don’t need to use all the money at once, you want to draw down the funds as you needed them. In that case, you would establish an equity, line of credit or draw down facility. The facility would have a limit and you would access the funds as you needed and only pay interest on the funds as you use them. It would be an option in circumstances such as home renovations wherein you only need to pay the builder once work is completed, or someone who may wish to invest in a shared portfolio and doesn’t require all the capital at once.

Accessing equity to invest should always be part of a well thought out plan and it would be best to consult with your financial advisor or accountant before speaking with your broker. Feel free to contact Pearl Financial should you wish to ask further questions or discuss your own personal circumstances.

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About the Author

Shane specialises in helping Gen Y professionals and business owners make an impact by accumulating more assets, generating more income, and having more time to enjoy life. He has a Master of Applied Finance, an MBA, and a Master of Financial Planning. He is also a terrible golfer.

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