Home Equity Loans

Home equity loans are a type of product offered by home loan lenders. They are often referred to as a second home loan. Borrowers considering this type of financing need to understand what these types of loans are, how they work, what they can be used for, and their advantages and disadvantages compared to other home loanproducts in the market.

What is a home equity loan?

Home equity loans allow borrowers to reborrow some of the equity (ownership) that they build up over time in their property. Borrowers can increase their level of home equity over time in three ways:

Via their regular home loan repayments that reduce their outstanding loan balance.
From their home increasing in value. Well-maintained properties in good locations in Australia have typically achieved long-term capital growth.
Through a lump sum to gain cash out in interest only separate split, which would allow you to replicate the functionality of a line of credit. However, this would have a minimum repayment once the balance is used.

There are two basic types of home equity loans.

A lump sum. The borrower reborrows an approved lump sum from the lender and makes their adjusted (i.e. increased) repayments over time.
A line of credit. The borrower is approved to reborrow up to a pre-defined limit and has the flexibility to reborrow (or not) as their circumstances change and needs arise. Repayments are adjusted based on any amount/s borrowed via the line of credit.

Just like the initial borrowing (i.e. the first home loan), a home equity loan (i.e. the second home loan) is secured by the value of the borrower's property. This security lessens the lender's risk of providing the funds to the borrower.

A variation on a home equity loan is a reverse home loan. A reverse home loan is a type of product that allows a property owner to relinquish their equity to a lender in exchange for receiving a lump sum, regular repayments or a line of credit. This type of home loan product may be suitable for retirees who need to generate cash flow for their living requirements.

No repayments are made on a reverse home loan loan, but the lender charges interest on any funds provided and it must be repaid in full when the borrower sells the property, moves into aged care or dies.

How does a home equity loan work?

The policies of different lenders vary in terms of the amount they are prepared to lend to borrowers for these types of loans. Most will be prepared to at least lend up to 80% of the home's loan-to-value (LVR) ratio either as a lump sum or as a line of credit (excluding reverse home loan products, where lenders have much lower maximum LVR lending policies).

The LVR is the amount of the loan expressed as a percentage of the market value of the home. For example, an 80% LVR on a house worth $600,000 is $480,000. A borrower with a home loan of $200,000 on this house would therefore be able to borrow up to $480,000 (i.e. an extra $280,000 as a home equity loan or a line of credit) from a lender who is prepared to lend up to an 80% LVR.

Many lenders will be prepared to provide home equity loans for even higher LVRs than 80%. However, they will typically require borrowers to take out lender's mortgage insurance (LMI) to compensate them for the increased risk. LMI protects the lender if the borrower subsequently defaults on their repayments.

What can a home equity loan be used for?

The funds can potentially be used for any purpose. For example:

For renovations.
To consolidate other high-interest debt that a borrower may have into a single amount at a lower interest rate. This can make it easier for borrowers to manage their finances.
For investments, such as the purchase of a business or investment property.

What are the pros and cons of a home equity loan?

Home equity loans have both advantages and disadvantages, just like all types of home loan products do. Whether they are a good option depends on:

The borrower's personal financial circumstances.
What the funds will be used for.

The advantages of a home equity loan:

Home loan interest rates will generally be lower than other types of products (like personal loans or credit cards) because of the high level of security that the borrower's property provides.
It can be easier for borrowers to obtain approval from lenders for a home equity loan than other types of home loan products.
The funds can be used for any potential purpose, providing borrowers with flexibility.
They can help borrowers unlock the equity in their property to use for other investments. These investments can provide borrowers with additional opportunities for capital growth, rental income and/or tax benefits (such as negative gearing an investment property purchase).

The disadvantages:

Borrowers taking out a home equity loan are taking on more debt, which increases their repayments.
A home equity loan attracts lender fees and charges.
There are more potential pitfalls and drawbacks than there are with a standard home loan, depending on what the funds are used for.

Pitfalls and drawbacks to a home equity loan

Like any loan, home equity loan products come with a degree of risk. In a worst-case scenario, borrowers can lose their property if they default on their repayments. In addition, there are some potential pitfalls and drawbacks that apply more specifically to home equity loans:

If the funds aren't used for investment (or if they are and the investment isn't successful), this places borrowers in a worse long-term financial position.
Borrowers who aren't financially disciplined can also be tempted to use home equity lines of credit irresponsibly, placing themselves in unnecessary debt.
Borrowers can potentially overcapitalise if significant home equity loan funds are used for existing property renovations. Overcapitalising is the term used to describe when the cost of a renovation is higher than the value it adds to the property.

The bottom line

Taking out any type of home loan is a major financial decision. The market is highly competitive and there is a vast range of products on offer from lenders, including home equity loans. It is worthwhile for borrowers to seek professional advice to secure the most appropriate home loan product for their individual circumstances.

If you're interested in a home equity loan book an appointment to speak with one of our home loan specialists. Or start to compare home loans online.