Three questions to ask before dipping into your home equity
If you find yourself among the lucky ones whose homes have been valued stratospherically in the past three years, you might be sitting on a huge sum of home equity that you can put towards
your next investment.
Called home equity line of credit home loans, this bank product category helps you tap into the value of your home.
For example, if your property is worth $1.2 million and you've got a $600,000 home loan against it, then you have $600,000 worth of equity that you can access for a line of credit facility with your bank.
Rather than charge you interest on that entire sum, you will only get charged on the funds that you withdraw. This is perfect for renovations to upgrade the value of your property or to fund your next property purchase.
As a rule of thumb, banks would put a safety buffer between the equity available in your home versus the equity available for your line of credit. This is generally at 20%. For example, you deduct 20% from $1.2 million, which gives you $960,000, less your outstanding debt of $600,000, and you get you a potential $360,000 line of credit facility (not $600,000 as mentioned in the rough calculation above).
The first thing you need to do is to get an up-to-date valuation of your home, although the lending bank will also do an independent valuation, which will be the deciding figure. Different banks might also come up with different values, so it's best to look at several choices.
Costs to look out for include the upfront fee (it could be hundreds of dollars) and the annual fee (from $300 to $400). Interest rates on these types of loans are also higher than a normal home loan and can range from 3.9% to as high as 6% (again, check with your bank or mortgage broker).
For example, with Greater Bank, prospective home loan borrowers could get a special 1.99% rate in February but for a line of credit facility the rate switches to 4.6%. There's a lower-than-average
$10 monthly facility fee.
Jessica Power, head of wealth and personal banking, Australia, at HSBC, says that on average, the account limit that people access is $300,000.
She says this product is more suited to investment lending. "For example, you could take out a line of credit and then draw on it if you needed a deposit for a new loan."
Here are three questions you need to ask yourself before applying for a line of credit with your bank.
1. Can you meet your loan repayments if your personal or work circumstances drastically change?
"When it comes to a line of credit loan, the key risk is that the limit doesn't amortise. So, the limit remains regardless of other circumstances changing such as property prices or income," says Power.
"While we cap these types of loans at 80% of the property value to help minimise the chance of a customer going into negative equity, the fact that the limit is evergreen means the risk is with the customer for longer."
2. Do you have enough cash savings in case interest rates rise faster than expected in the next few years?
Lines of credit have a variable rate, which means that it can change through the life of the loan.
Because the limit doesn't amortise, there is a greater risk of rate fluctuations, says Power.
3. Do you have an exit strategy for the loan?
Because the loan is interest-only, you could end up carrying the debt well into retirement age, depending on the amount. Power says this could cause issues, given changes in income levels from when the loan was originated.
One thing you can do is check with your lender if you can make lump-sum repayments or pay off the loan faster without incurring any penalties.
With prudent management of the repayments, you can have the same credit limit for the life of the loan even if your financial circumstances change. This is handy in times when your finances may be stretched temporarily or if you are looking to change jobs but don't want that decision to affect your existing loan.
A line of credit facility would only be revoked if you defaulted on the loan or broke any of the conditions and contract terms, including fraudulent behaviour.
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