Making the most of home equity

If you’ve owned your home for some time, it’s a fair bet the property is worth a lot more now than when you bought it. As a guide, six years ago in 2015, the median Sydney house price was $900,000.  Today, that figure is close to $1.2 million. The difference of $300,000, represents additional home equity. Of course, plenty of people would have even more equity, as they’ve been steadily paying off their home loan.

In previous generations, home equity could only be accessed by selling a property. That’s not the case today, and your equity is a valuable financial resource that can be used to build additional wealth. It’s all about borrowing against your equity, and using the funds to invest in shares, exchange traded funds (ETFs) or a rental property.

Let’s say for instance your home is worth $700,000. You can borrow up to 80% of this value – or $560,000. We’ll also assume you  have $400,000 owing on the home loan. That leaves you with equity of $160,000 ($560,000 less $400,000).

Many lenders will let you use this equity as security on another loan to buy, say, a rental place. You don’t need to pay a cash deposit, which helps to preserve savings. And, if the loan is used to fund income-generating investments, the interest is usually tax deductible. This provides tax savings, which along with investment returns, can be used to pay down your home loan.

In this way, you whittle away non-tax deductible debt (your home loan) and replace it with tax deductible debt used to fund income-generating investments. This explains why this strategy is sometimes referred to as debt recycling.

 Is there a catch? Yes, there can be several.

Even if you’ve built up plenty of equity, there’s no guarantee banks will let you borrow against it. Lenders look at other factors including your income, household expenses and any additional borrowings to check you can service the debt.

If you do get the green light to borrow against your home, it’s important to speak with your accountant and mortgage broker about how the investment loan is structured. The Tax Office likes to see a clear distinction between interest that’s tax deductible and interest charges that can’t be claimed on tax. So you’ll typically need to take out a second, separate loan or at least divide your mortgage across two ‘buckets’ that clearly spell out the interest cost relating to your investments (deductible), and the interest that applies to your home (non-tax deductible).

As debt recycling involves taking on more debt, you’re looking at bigger repayments. The ongoing returns on investments, such as dividends, rent or distributions from ETFs, can help to cover the loan repayments. But there may be a shortfall. You need to be sure you can comfortably cover this gap.  

More importantly, think about your life stage. I’m a big fan of entering retirement with as little debt as possible – in particular having your home loan paid off. Dipping into home equity to take on more debt has the potential to leave you still paying down a solid chunk of debt in retirement.

With interest rates at record lows, it’s very cheap to borrow money at present. However, rates won’t always stay this low. That’s why it pays to stress-test a debt recycling strategy to be sure you could comfortably keep up loan repayments if rates rise, if your investments dish up lower-than-expected returns, or if you lose your regular wage or salary for whatever reason.

Effie Zahos is an independent Director of InvestSMART, money commentator at Canstar.com.au and Channel 9 Today Show.