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If you own your home or an investment property, chances are you have some home equity – and it could be a surprisingly useful financial tool.
The term ‘equity’ simply means ownership, so home equity refers to the extent of ownership you have in your home. It is measured by the difference between the balance of your home loan and the market value of your home at any point in time.
One of the great aspects of home equity is that it tends to increase over time - often without any effort on behalf of the home owner. A well chosen property should rise in value over the long term, and by steadily paying off your loan, the value of your mortgage decreases. The growing gap between the two – the property’s value and the loan, represents the ongoing increase in your home equity.
Not so long ago the only way home owners could access their home equity was by selling up and upgrading to another property.
These days, mortgages are very flexible, and it’s possible to make use of home equity without the need to sell a much-loved home. It’s often achieved by refinancing your current home loan and using the funds provided from the newly enlarged loan to achieve a range of personal goals.
As a guide, home equity can be used as a source of low cost funding for a new car, home improvements, a special holiday – in fact just about whatever purpose you choose. As home loan interest rates are generally much cheaper than other types of credit, like a personal loan, home equity can offer a very affordable source of funding.
It’s also possible to use home equity to grow your wealth. Some home owners for instance choose to use their equity as a deposit on a rental property. This expands your property ownership and provides a source of rental income, which can be used to pay off the loan.
Work out your home equity using this formula:
Property's market value - Remaining loan balance = Your home equity
For example, if your home is worth $700,000 and there is $300,000 remaining on your home loan, you have home equity worth $400,000.
However, bear in mind that not all of this will be accessible, with lenders only allowing you to borrow 80% of the property's value without being charged for Lender's Mortgage Insurance (LMI).
In other word, to avoid paying LMI, keep your Loan to Valuation Ratio (LVR) below 80%. In this given example, that means:
So in this example, the amount of equity you can access without incurring LMI would be $260,000.
Remember, even if you have already paid LMI before, you would still need to pay it again if you try to access equity that exceeds 80% LVR.