Equity Talk: More than just a home loan

Equity Talk: More than just a home loanTraditionally the homeowner mortgage was a thing that stood by itself, without added features or ‘frills’. Investment loans, car loans and personal loans were separate mortgages independent of equity in the home. The homeowner met home-loan repayments from after tax income, and investment loan repayments from tenant rents.

The traditional home loan took a long time to repay, often over twenty years. Further, homeowners might find themselves ‘asset rich'; having repaid most of a loan on a home that had greatly increased in value, and yet be ‘cash poor’.

Today’s lender has had to change to ‘meet the market.’ The phenomenal growth of mortgage originators has forced traditional banks to offer loans that include provisions for the range of financial and taxation needs of their customers. One of the major innovations in the past few years has been the Home Equity style loan. Put simply, this allows a second mortgage against the value, or equity, built up in your home.

Home Equity Loans have already become almost the norm in the US. By one reckoning, 25% of the mature baby boomer generation currently has Home Equity style loans, as well as 19% of their children, Generation X (1998 National Housing Survey, Fannie Mae).

Home Equity Loans can be used to consolidate debt, including credit card debt. The danger with this is it can too easily become another credit card style debt, as in a Line of Credit Loan that gives ready access to cash. However a Home Equity Loan can also be used to tap the equity value in the residential home to make more productive investments in property or the stock market. All this is made possible because of the steady growth in equity built up in the home. Many will have found that since purchase their home has appreciated in value. Others have gradually built up considerable equity in their home by the principal portion of each loan repayment.

Lenders are now offering a variety of loans which meet the need to release equity value. These can be grouped into three broad classes of loan.

Firstly, there is the basic Home Equity loan. Here you get cash in one lump sum, and start paying interest on it from day one. The upside of this is that you may get sufficient cash for that large project or productive investment. It would otherwise be very difficult to save such an amount from your after tax earnings. The downside is that you will be paying interest on this straight away. It is essentially an additional mortgage which will typically allow you to access 80% of your home’s value, or less in rural areas.

The second newer type of loan is a Line of Credit. Here you only pay interest on the amount of money that you have withdrawn. The downside of this is that you will need to be disciplined to avoid using up all the equity in your home for consumption expenditure.

The third option is to refinance your existing mortgage. If you want to take cash out when you refinance, lenders will typically provide around 80% of your home’s current market value. The positive here is that you’ll have only one mortgage payment with probably lower interest rates. However, if you need to refinance for more than 80%, you will need to get an Equity loan on top of your home loan, and you would be better placed getting just the one Equity style loan, to avoid duplication of charges. One suggestion, instead of a refinancing, is to look closely at your lending terms, or to ask your lender, to see if you may be able to obtain some of the new terms you want by agreeing to a modification of your existing loan.

Refinancing can be a good idea for homeowners who want to build up equity more quickly by converting to a loan with a shorter term or who want to draw on the equity built up in their house to provide for an investment. The idea is to work harder to be free of debt sooner.

Refinancing only becomes worth your while if the current interest rate on your mortgage is at least two percent higher than the prevailing market rate.A general rule is that refinancing only becomes worth your while if the current interest rate on your mortgage is at least two percent higher than the prevailing market rate. This figure is generally accepted as the margin of balancing the costs of refinancing a mortgage against the savings.

The second general rule, given the high costs of refinancing, is that it takes at least three years to fully achieve the savings from a lower interest rate.

Another important innovation by lenders in the past few years, which can also impact on your property equity, are the various Offset and Redraw style loans. These make use of your income to cut interest payments on your loan, by using it as a deposit account. This style of loan can help you reduce your total repayment period by months or even years if you are disciplined. Most benefit is gained by depositing all available funds into your mortgage account. You pay no tax on interest earnings because you receive no interest. Instead of making extra repayments into your loan, you deposit these funds into your loan account. With many accounts you also retain access to all your funds, (though the redraw availability of funds differ from lender to lender). Without this feature your interest would normally be paid into a traditional every day account, and you’d pay tax on it. However, with offset style loans, the interest savings reduces the length of your loan. Clearly though you need to be careful both in terms of what interest rates are actually offered, and that you don’t redraw too much from your loan. This can impact negatively on your property equity, and it may actually take longer to pay off your loan.

In fact this goes as general advice for all these ‘more than a basic home loan’ style mortgages. The bottom line is always what offers the best value for money. So look closely at the interest rates and charges of whatever style loan you sign up for. Also, be realistic about your spending habits. For most of us, a basic home loan still remains one of the best ways of enforcing savings. We usually find it easier to meet regular payments than to control our spending! The problem with equity style loans is that they allow us to reduce equity. Building equity in your own home is long hard process, and is the only way you will eventually be free of the burden of debt.

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