Home equity: What every investor should know

You can often access part of that increased value for further investment, either through a redraw facility in your existing mortgage, or through another loan, with the larger share of your home acting effectively as collateral for the new lender.

This use of home equity, whether for investment in a new property or improvements to the existing home, is a common wealth-creation strategy for many owners. It allows you to tap into the rising value of your home over time, as well as the increased share of that asset that you take with each repayment of the principal part of your mortgage.

There are, of course, risks to every investment. Here are four things you need to think about before drawing from the well of home equity.

Don’t use everything at once

Equity is the difference between your home’s value and what you currently owe on your mortgage. When you first took out your loan, it would have been equal to the deposit or down-payment you made (most often 20 per cent).

With a full-offset mortgage, you can draw down further than this level, but it is a good bare minimum equity to aim to retain. A larger buffer will help to give you some space if things don’t go to plan.

Invest wisely

Just because the equity is available, that doesn’t mean it should be used for just anything. Using home equity involves an increase in debt that will need to be repaid – so if your current income doesn’t cover the total repayment, the new investment needs to bring in a new revenue stream, such as a long-term tenant in a new investment property, as soon as possible.  If you can service the increased debt, you have a broader range of options – just remember the next piece of advice.

Consider your ability to service two (or more) loans

At some stage, all the loans have to be paid back, even if it’s a lump sum with the resale of the investment asset – hopefully including a significant capital gain. But between the purchase and conclusion of each loan, at least interest (but more often principal as well) will be payable, albeit at the more favourable rate of a home loan.

Consider this situation as you did when you first took out your original mortgage: balancing your income against a sensible repayment plan. If they don’t match, it might be wise to wait a little longer before dipping into your equity.

Budget conservatively

That process requires an extra level of conservativeness with a home equity loan. Test your plan against the possibility of interest rate rises, but also consider the chances of a fall in property prices. This can happen. In fact, some commentators are expecting a drop-off in home values in Sydney and Melbourne in the very near future. Be prepared for this extreme, and you’ll be well placed to weather any other type of storm that arises. Failing to plan for the possibility could lead you to pay the ultimate price – a foreclosure of your home.

Home equity is a valuable resource for all property owners and can be used to start a wealth-generating property portfolio that will set you up for life. But it’s not free money. As with any loan, owners need to carefully weigh up the potential risks against the rewards on offer. Both are potentially life-changing.