Buying a property with a home loan typically means using the property’s value to secure the loan; a practice called mortgaging your home. But it’s also possible to use the value of your property as collateral on another loan, provided you fulfil the eligibility criteria and have enough usable equity available.
What is collateral or security on a loan?
When a bank or similar financial institution lends you money, they’re taking a risk that you may not pay them back. The higher a lender feels this risk is, the more the lender may charge in interest and fees on the loan.
To help reduce the lender’s risk (and the cost of your own loan repayments too), you can offer the lender security or collateral for the loan. This is a valuable asset that the lender can legally repossess and sell if you default on your repayments, to help them recover their money.
Most home loans are secured by the value of the property being purchased. Many car loans are also secured by the value of the car you’re buying. For some credit products such as personal loans, it’s possible to use a separate asset as collateral in order to help reduce your interest charges. This could be a cash in a term deposit, assets such as shares, valuables such as jewellery or fine art, or the value of a car or the equity in a property.
What is equity?
Equity is the name for the percentage of your home that you own outright, and doesn’t have a mortgage owing on it. A fast way to find equity is to use this formula:
Making extra repayments on your mortgage can help to quickly lower your mortgage principal and increase your available equity. Also, if your property’s value has risen since you first purchased it, you may find you have more equity available than you expect after a valuation is completed.
Keep in mind that not all of the equity in your property can be used as collateral, as part of it will be required to secure your current mortgage. If more than 80 per cent of your property’s value is being used to secure finance, your lender will likely take out a Lender’s Mortgage Insurance (LMI) policy, which you, the borrower, will likely need to pay for.
For example, if your property is worth $500,000, and your mortgage has an outstanding balance of $300,000, you have $200,000 in equity. But because 80 per cent of the property value is $400,000, that leaves only $100,000 of equity available for use as collateral on other loans.
How can you use equity?
You can use the equity in a property as security or collateral on a new loan. You may be able to apply for a mortgage on an investment property, using the equity in your current property in place of a traditional deposit.
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When considering buying an investment property using your equity, a common benchmark is to look at properties with a purchase price of around four times your usable equity. For example, if you had $100,000 in usable equity, looking at properties priced around $400,000 may allow your equity to cover a deposit on the property, as well as upfront costs such as fees an stamp duty.
You may also be able to apply for a line of credit with a maximum limit based on your equity, which functions much like a credit card. In a home equity loan like this, you’d only be charged interest on the amount you’ve borrowed and would get to enjoy some flexibility around your repayments. This flexible access to money could help you to manage the costs of a renovation to your property, or go on a holiday, or invest in assets such as shares.
Keep in mind that borrowing money is always a risk, which could affect your financial future. Before putting your equity to work, consider seeking independent financial advice and/or contacting a mortgage broker.