What is equity?
Being in the finance industry, I see the word ‘equity’ thrown around a lot. Where I tend to see it used the most is when it comes to property investment. Regularly I see comments talking about ‘releasing the equity in your home’ or ‘wasting your equity’.
So what is it?
Well in accounting terms, equity is the difference between the value of something you own and the value of the debt you have remaining on that thing you own. A simple example is your home. If your home is worth $300,000 and you owe $100,000 to the bank, you have $200,000 in equity. In my opinion a better perspective to explain this is that you own 2/3 of your home and the bank owns 1/3.
Why is equity important?
Well owning your own house when you haven’t paid down your mortgage is not really ‘owning’ the house. What you are doing is living in a house that is owned by your bank. As you pay down your debt however, that house becomes increasingly owned by you until finally, you can tell the bank to take off as the house is entirely yours.
Should I release the ‘equity’ in my home?
A common thing I see mainly advertised on my Facebook feed is that I should be ‘releasing’ the equity in my home. The more extreme examples of this is where the ad is telling me that I am ‘wasting’ the equity. So what does this mean?
In its simplest form, these ads usually relate to purchasing investment property. What they are essentially saying is that you could borrow money to buy more property and use the value in your home as collateral. I’ll give you an example of how this would work.
If you owned a home worth $500,000 and had paid off none of it, then you would have no equity. If you wanted to buy an investment property worth $500,000, the bank would look at the risk and consider that loaning you $1,000,000 is risky. If the properties went down in value by 20% (i.e. your homes were worth $800,000) and you stopped making your payments, then the bank would suffer a $200,000 loss when they took the homes from you and sold them (usually making you bankrupt in the process).
In another example however, lets say your home is worth $500,000 but you have paid off $300,000. You ask the bank to borrow another $500,000 to buy an investment property. The bank would now be only loaning you $700,000 (the $500,000 investment property and the $200,000 left on your family home). If things went wrong, they could take both homes and sell them. If they had dropped in value to $800,000, they would get the entirety of their $700,000 back. This is by far a lot less risky for the bank.
Basically, having equity gives the bank confidence that if you default on your loans, they are more likely to get their money back. The reason they can do this is they have a ‘mortgage’ over your home which means they have an interest in it and can take it from you.
So should you release the equity? Well that is a bit of a misleading term. The question is whether you are willing to risk your house and everything you have paid off on your new investment. This depends on your risk tolerance. Some people in the past have taken this gamble and won, others haven’t been so lucky.
So am I wasting my equity?
I can definitely say that nobody is ‘wasting’ their equity. Investments can go up and investments can go down, particularly when it comes to investing in residential property. When somebody tries to convince you that you are ‘wasting’ your equity, what they are saying is that the investments are such a sure thing that if you aren’t using your home as collateral to invest, you are leaving money on the table.
But an investment is never a sure thing. Depending on the type of investment and the amount of risk involved, you need to consider whether you are comfortable putting your family home up as collateral. If you choose to do so, its important that you have a plan which addresses what you will do if the investment goes up but more importantly, how long you will let it go down.
Once again, if you have any questions please feel free to reach out.
This post is from our resident Financial Planner Ben Brett, check out his details in the About Us section.
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