If you’ve owned your home for several years, there’s a good chance you’ve accumulated some equity.
Equity is the difference between the value of your home and your outstanding mortgage, and can be expressed as a number or percentage.
Example of how to calculate equity
In summary, you can calculate the equity in your home by considering the property value minus the loan balance. Therefore, if your property increases in value and you pay down your loan, your equity increases.
For example, if you originally bought a $1 million home with a $200,000 deposit and $800,000 loan, your starting equity would’ve been $200,000 / 20% (while the lender’s would’ve been $800,000 / 80%).
If your home had since increased in value to $1.2 million and you’d reduced your loan to $744,000, your equity would’ve increased to $456,000 / 38%. (That’s because the difference between $1.2 million and $744,000 is $456,000, and $456,000 is 38% of $1.2 million.)
Total equity vs useable equity
The reason equity matters is because you can potentially borrow against that equity and use those funds to renovate your home or put down a deposit on an investment property. In other words, you can convert your paper wealth into functional cash.
You can’t ‘cash out’ all of your equity, because your lender will want you to maintain an equity buffer in your property. That’s to reduce their risk – because if you default on your mortgage and the lender seizes your home, they need to be sure the sale proceeds will cover the outstanding debt.
Generally, lenders are comfortable with homeowners reducing their equity to 20%. It’s possible to go beyond this, but lenders will generally expect the borrower to pay lenders mortgage insurance.
So as a general rule, assume your ‘useable equity’ would be your current equity stake minus 20%. In our hypothetical example, that would be 18% (i.e. 38% minus 20%).
How to capitalise on your equity
As part of the process of tapping into your equity, the lender will generally conduct a formal valuation of your property and expect you to refinance your loan.
That means you’ll need to again prove your creditworthiness to your lender (or your new lender), even if you’ve been making all your mortgage repayments on time.
So it’s best to approach this process as you did when you originally took out your loan, which means restraining your expenses and getting your documents in order.
Is borrowing against your equity right for you?
Cashing out equity can be a clever (and profitable) financial strategy. Bear in mind, though, that it involves risk, because it means taking on more debt, so it’s not suitable for everyone.
Get in touch with a broker if you’re thinking about tapping into your equity. They can calculate how much equity you have, explain how you might be able to use that equity, and outline the pros and cons of your options.
