When to consider a home equity loan instead of a mortgage

If you already own a property and are considering purchasing a second, you may assume that you must start saving for a deposit and then take out a new mortgage for the property. However, you may want to consider how a home equity loan may also help you achieve your goals.

A traditional mortgage involves saving up a deposit and applying for a loan with a lender. But for those who remember how hard saving for their first deposit was, scraping together tens or hundreds of thousands of dollars isn’t just going to come from under the couch pillows.

Saving a deposit can be a considerable barrier for homeowners looking to purchase another property. This is where a home equity loan may come in handy and be another option to consider to help you achieve your goals, instead of a traditional mortgage.

What is a home equity loan?

A home equity loan is when a homeowner leverages the accessible equity in their home as security to borrow money. This is typically done for the purpose of a home renovation, for big events like a wedding, or as collateral for an additional property.

In the instance of a homeowner wanting to purchase, say, an investment property, they can promise a percentage ownership of their existing home in the event of a default as opposed to saving up a deposit. You aren’t giving the lender hard cash as you would have for your first home loan but using the accessible equity in your current property instead.

This can be a competitive option for some home buyers to consider if they want to snap up a new property quickly and take out a mortgage to pay for said property, without waiting for the time it would take to save a deposit or having to sell your existing home for the cash.

Calculating your accessible equity for a home equity loan

Your property equity is the difference between the market value of the home minus the balance of your current home loan. The more you chip away at the principal owing on your mortgage, and the more your property increases in value, the more equity you may have.

However, your home loan lender is unlikely to let you access the full amount of equity available, and you may not want to as this can be financially risky. This is where ‘accessible’ equity comes into play. You may be able to instead access a limited percentage of your equity to ensure that your current mortgage maintains a healthy loan-to-value ratio (LVR), generally around 80%.

For example, you take out a $480,000 home loan to purchase a $600,000 property. You paid a deposit of $120,000, or 20% of the property’s value. After several years you’ve decided to purchase a new investment property.

At this point you’ve now repaid an additional $100,000 from the principal owing, so your current mortgage balance is $380,000. The property’s value has also increased in this time to $700,000. This means that the property’s current market value ($700,000) minus the mortgage balance ($380,000) would be the total amount of equity - $320,000.

But, as mentioned above, your lender won’t let you access this full amount as you need to maintain your LVR of 80%. Instead, your accessible equity is 80% of the property’s current value ($560,000) minus the current mortgage balance ($380,000). This brings your accessible equity for a new investment property deposit to $180,000.

What happens if you default on the home loan?

If the worst-case scenario of defaulting on the new mortgage were to occur, it’s worth keeping in mind that you cannot just give a lender, say, 20% of your property’s accessible equity that you offered up as security.

Instead, it’s likely that you will need to sell the existing home and provide the lender with the portion of the loan value that you secured for the second mortgage. In this same example, the lender would get 20% of the sale price of the existing property.

In the instance that you default on the second mortgage, you will not only lose the new property to repay the mortgage, but likely have to sell the existing property. This is a considerable risk to take on board, so ensure your finances are healthy and you are in a good position to repay your new mortgage before you consider a home equity loan.

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