Investing Your Home Equity: The Good and Bad
When you realize there is equity in your home, your mind comes alive with possibilities â€“ everything from a shopping spree or a wedding to a holiday or a renovation. However, while your equity can seem like money in the bank, spending your equity is not the same as dipping into your savings account â€“ with a savings account you can work hard, and harder, to replenish the savings you use, but with your home, there is very little you can do to regain equity you have spent, except wait and hope for more capital gains.
Therefore, while it is tempting to tap into your home equity for immediate lifestyle indulgences, never forget the dangers of using your equity for depreciating assets, and the risks of a higher mortgage and a higher loan to value ratio. Instead, if you are considering accessing your equity, make sure you put it to work, making sure the returns are worthwhile and that the benefits and appreciation outweigh the risks.
To successfully invest your home equity, you need to follow these five steps, to keep in mind the risks, and maximize the reward.
1 â€“ Assess current credit and debt levels
While accessing your home equity is really just tapping into the capital growth your home has seen since you bought it, to do so you are actually increasing the size of your home loan. If you were to access the equity as cash, it would be the profit you made from the sale, after repaying your home loan, however, since you want to continue living in your home, you have to have the bank advance you the equity in the form of an increase in your mortgage amount.
Therefore, before you decide to invest your home equity, you need more make sure you can afford to increase your debt levels. You can do this by assessing your current budget and spending to make sure you have enough funds to maintain your lifestyle, and with higher loan repayments you will still be able to spend less than you earn.
Assess your current budget and debts by:
- Writing down your current take home pay. This includes all income which comes into your household from work, and other investments you already have. Make sure the amount is after tax.
- Deduct your expenses. List and deduct all of your expenditures including: your savings contributions; your mortgage repayments or rent; utilitiesâ€™ food; transport including fuel; child care; medical care and health insurance; clothing; and activities and recreation. Donâ€™t forget to include payments you make on a quarterly or annual basis such as taxes.
- Deduct your existing debts. This is where you include your student loans, your credit card debts and car repayments.
The amount you have left at the end is the amount you can responsibly put towards your higher home equity loan. The amount of the remaining balance you choose to allocate to your home equity repayments will depend on your situation, and whether you want to rely on your savings account for emergencies, and how long it will take to replace those funds when there is an emergency.
2 â€“ Property values and overvalue
The amount of the equity in your home you borrow will also depend on your lender, and on your application. In most cases you are able to borrow up to 80% of the equity available in your home, to minimize the risk of the value of your loan being higher than the value of your home.
To access your home equity you will undergo another borrower assessment and application to determine your ability to repay a higher loan amount. However, in addition to the bankâ€™s assessment, also make your own assessment on how much of the equity you want to draw down on.
You can do this by looking at the property values of other similar homes in your area and compare their features to yours. Be realistic about the value of your home to ensure you donâ€™t borrow more than your home is worth â€“ for example are you in a boom area, with inflated property prices? If so, will the boom continue, and for how long? Look for new opportunities in the area, new infrastructure projects and lifestyle factors which will continue to drive demand in your neighbourhood.
Also remember that while property values go up in the long term, sometimes there are periods of stagnant or negative growth. Therefore, while the overall outlook will show rising property prices, if you have to sell your home in the middle of a slump, there could be little or no difference between the selling price of your home, and your remaining loan amount.
3 â€“ Choose an investment type
To make investing your home equity worthwhile, profitable and safe for the family home, you need to choose the right investment to make. Make sure you spend your home equity on an appreciating asset such as shares, or an investment property.
You can also use your home equity to accumulate more equity by making improvements to your home. Accessing your home equity for renovations, extensions, a new kitchen or a new bathroom can add tens of thousands of dollars to the value of your home, without you having to use all of your equity.
Just make sure that if you invest in your own home, you donâ€™t overcapitalise because turning your three bedroom house into a five bedroom house with home theatre and pool in a neighbourhood of three bedroom houses can make it harder to sell, as the people who can afford the house, arenâ€™t looking to live in your suburb, and the people who are looking to live in your suburb, canâ€™t afford your house.
4 â€“ Secure investments
When you draw down on your home equity, your property remains as security against the loan, in case you default on your repayments. Therefore, to maintain the security of your family home, you need to make sure you can cover the higher mortgage repayments easily, without relying on the returns of the investment you make with your equity.
While you of course want your investment to succeed and grow, with every investment there is a gamble, and you need to be able to meet your mortgage repayments even if the gamble doesnâ€™t pay off. If youâ€™re worried about risking the security of your family home, there are other investment options such as a margin loan which can reduce the risk.
Even though you shouldnâ€™t be relying on your investment income to cover your mortgage repayments, you can make sure the investment is worthwhile, by setting a desired rate of return. For example, if you are paying 6% interest on your home equity loan, you want to make sure your investment returns are at least 8% so your investment is worthwhile after interest and bank fees.
5 â€“ Investment income and interest charges
When you are looking for a home equity loan, make sure you closely compare interest rates, because while you may have secured a great low interest rate on your mortgage, when you apply to borrow your home equity for investment purposes, the lender can see that as a greater risk, and apply a higher interest rate to your home equity loan.
If you canâ€™t find a more competitive interest rate, it could be time to take a cue from your lender and lower your risk by borrowing less equity. For example, instead of borrowing the full 80% you are approved for, borrow just 60% for reduced risk to your home and family, and a reduced interest rate.
Once you have secured the best interest rate, you will be able to work out what you need your investment returns to be. In most cases a 1% profit margin may only be enough to break even after loan fees, and time spent, therefore, if you are paying 6% interest on your home equity loan you may want to look for investments which will return at least 8% to make your investment worthwhile.
Also keep in mind that while the interest and fees on a separate margin loan for investments can be claimed at tax time, when your home equity loan for investments is part of your mortgage, you have blurred the line between persona l and investment lending. As a result it may be harder if not impossible to claim your investment expenses at tax time.