Using Home Equity

Before we go into the nitty-gritty of using home equity to your best advantage, let's explain what equity really means.

What does equity mean?

Equity really has two meanings. First, it means the value of your house that is not encumbered by a debt. For instance if you have a house worth $500,000 and an existing home loan with a balance of $300,000, you have $200,000 unused equity.

Secondly, lending equity means that you can borrow against your own use equity, but not the full 100%. In a nutshell, most banks will lend you up to 80% of the house's value without having to pay mortgage insurance (or 90% if you are prepared to pay Mortgage Insurance), so in the above example the maximum loan the bank may be prepared to offer would be $400,000, which means you can borrow an extra $100,000 on your home loan without having to pay lenders mortgage insurance.

You can see the difference between real equity and borrowing equity through this example.

Here is a summary of the rules that come into play.

Most lenders will be happy to refinance a home loan up to a maximum of 90% of its market value. Remember, if you borrow more than 80% of your house's value you will have to pay lenders mortgage insurance.

The market value for a home is determined by a valuer appointed by the bank and is quite likely to be lower than your expectations. This is something which catches many borrowers unawares but there is no point complaining to a bank because of a low valuation as they are very unlikely to change their mind or request another valuation.

If you refinance your home loan to a new lender and wish to consolidate some of your smaller existing debts, you should be aware that some lenders have limitations on how many debts they are prepared to incorporate into the new loan.

When you are transferring your home loan to a new lender you will need to provide six months home loan statements to prove you are making your repayments on time. As well, you will also need to supply up to 6 months statements for any loans you wish to consolidate. This gives the new bank a chance to look at your loan history and to judge whether or not you are a good risk.

You will have to pay for the valuation on your house as part of the loan application fee, and this will not be refundable even if you do not get a favourable value and decide to withdraw your application.

Now that you are aware of the conditions under which the bank will allow you to use your remaining equity, it's time to look at whether it's really worth it or not.

Previously, we looked at an example of a couple who owned a house with a value of $500,000 and an existing home loan of $250,000. They were able to incorporate a personal loan and some credit cards and roll their total debt into one loan of $268,000 and save themselves several hundred dollars a month.

This is a good example of how using equity can ease the cash flow and make life financially more comfortable. Nevertheless, there are a few things to consider.

Personal loans are paid over a short term, usually 5 to 7 years.

Refinancing personal loans into a home loan means that the debt will be repaid over 30 years or whatever the home loan term is. This can mean that the total interest paid will be substantially more.

There is no doubt that debt consolidation can certainly make life a lot easier as the following example demonstrates.

If a borrower is paying for an $11,000 personal loan over five years at 11% interest the required monthly repayment would be $236.99.

If the same loan was incorporated into a home loan over 30 years at 7% interest, the required monthly repayment would be $72.76.

On the face of it, this looks like a substantial saving and it certainly makes cash flow much more favourable to the borrower. On the other hand however, the total repayments made tell a completely different story.

First, the personal loan taken over its original five-year term would mean that the borrower repays a total of $14,219.40. But the same amount of money taken over a 30 year term home loan would mean the borrower repays a total of $26,193.60!

So, what's the point of taking out a home loan to consolidate debt if you end up paying more? The answer lies in how you manage the home loan.

The trick is to make sure you make the same monthly repayment into your home loan that you would have into the personal loan. In other words by paying $236.99 into the home loan, the $11,000 debt would be paid off in just under 54 months which means the borrower would save $1421.94.

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