What is home equity, and how is it calculated?

Your home equity is the value of your financial stake in your home, and it’s an important number to know whether you’re at the start of your home loan or ready to refinance. 

Equity typically accumulates over time and lets you know how much wealth you’ve locked into your property. And because it’s a form of wealth, it can be used to help fund some big life changes. 

So let’s get into the nitty-gritty details. What is home equity, how is it calculated, and how can you use it?

Home equity is the value of your property minus any debts you have on it, such as a mortgage. You can think of home equity using this equation:

Home equity ($) = Home value – loan value

Home equity can be expressed as a percentage (“I have 20% home equity”) or a dollar value (“I have $50,000 in home equity). Either way, they essentially describe the same thing: what your homeownership is worth.

HOT TIP: Equity is similar but not the same as your loan-to-value ratio (LVR) – but we get into that in a different guide.

To calculate your home equity, you need to know two essential things: the value of your property and the value of any loans against it. 

Your property value is typically determined by the purchase price and any capital gains. The most surefire way to know your home value is to get a professional property valuation. 

A property valuator can consider market forces, condition reports, and valuable additions such as energy-efficient features when coming up with a price for your home.

Once you have this number, total all your debts against the home next. This includes mortgage debt and personal loan debt, such as from any renovations. If you’ve been paying off your home loan for a while, the mortgage debt to consider is your loan balance, or outstanding principal – i.e., how much you have left to pay.

Altogether, your home and loan values can tell you how much home equity you have accumulated.

Home equity ($) = Home value – loan value

All that’s left to do is use the equation!

Because home equity is a part of your asset wealth, it can be used for things like funding an investment property, renovations, or, in some cases, retirement (see our reverse mortgage guide). 

The main way you do this is by taking out a ‘second’ home loan, called a home equity loan, and refinancing your current loan. We outline the process and what an equity loan is below.

Let’s say you want to use your home equity as a source of cash flow. Here is the basic process:

1. Step one: calculate your equity. Work out how much home equity you have based on the market value of your home, minus any loan amounts against it.
2. Step two: calculate your accessible equity. Once you know how much equity you have in total, you need to calculate how much you can use and how much you need to achieve your goals. Using your home equity may involve making additional mortgage repayments later, so you need to know your serviceability (i.e. how much extra mortgage you can finance) based on your current income and living expenses. 
3. Step three: compare your home loan. Now’s a good time to check your home loan health. Compare your current mortgage to others on the market, looking particularly at interest rates, fees, and features that could save you money, such as offset accounts. If you find a home loan that works better for you, it could be time to switch.
4. Step four: compare the costs of using your home equity. There may be fees, breaks costs, and other charges associated with accessing your home equity, such as Lenders Mortgage Insurance (LMI) or government taxes. Investigate how much it money it could cost you in the short term and long term. A financial planner or mortgage broker can help you here.
5. Step five: submit your home loan application. Using your equity will require you to submit a new home loan application, whether you’re staying with your current lender or switching to a new one. You will need your standard home loan application paperwork. Once your application is approved, you can proceed to settlement. 

If you want to become a guarantor on someone else’s home loan, you can also sometimes use your home equity as collateral. This can be a great way for parents who’ve been homeowners for a while to help their children get on the property ladder.

A home equity loan is a second mortgage loan you can take out that lets you borrow from your home equity. 

There are two main types of home equity loans:

• Lump sum. The borrower takes out a lump sum from their equity and makes increased repayments over time to cover it.
• Line of credit. The borrower gets access to cash flow from their equity (up to a preset limit) that they can increase or decrease based on their needs. Repayments go up or down based on the amounts borrowed from their equity. 

The lump sum is typically used for funding major projects like an investment property or second home, while the line of credit is typically a feature of reverse mortgages as a retirement funds option in addition to pensions and superannuation. (Remember that reverse mortgages come with their own fees, interest, and repayment obligations, however). 

Just like your first mortgage, your home equity loan uses your property’s value as security. Different lenders will have different criteria for how much they feel comfortable lending. Most will probably let you borrow from up to 80% of your home’s LVR. 

If you want to borrow more than 80%, you may have to pay LMI to protect the lender in case you default on payments.

Property is an important investment because it lets you lock wealth into one asset in the form of home equity. And using your home equity comes with many advantages, too. 

For instance, here are some key pros of using home equity:

• Use what you have. It lets you access funds based on the wealth you’ve already accumulated in property.
• Interest rates. Home equity loan interest rates are typically lower than standard personal loans and credit cards because you use an existing property as security. 
• Approval. Lenders are more likely to approve a home equity loan than other types of home loans, meaning there’s less financial risk and credit history implications for you. 
• Flexibility. You can use the home equity funds for nearly any purpose. 

However, there are some drawbacks to using your home equity, too.

• Debt increase. By borrowing from your home equity, you actually increase your debt. This could make it take longer to fully pay off your original home loan. It also increases your monthly mortgage repayments. 
• Fees. You may have to pay lender fees and charges on the home equity loan. 
• You get into financial trouble. For example, say you borrow a lump sum from your home equity to fund an auction deposit, but the auction goes wrong – maybe you overbid – and you lose your deposit. You lose the money you took out but still have to pay back more on your original home loan. If you’re using the equity funds for renovations, you could also ‘overcapitalise’ by investing more money in renovations than the value they add. 

Either way you slice it, using your equity is a major financial decision that requires careful research and planning. A financial advisor can help you determine if it suits your needs.

One of the main home loan dangers to watch out for is negative equity. Negative equity is when you owe more on your home than what it’s worth. 

Negative equity is mostly a problem if you plan to sell. Selling a property with negative equity means you’d make a capital loss on it, so it sells for less than what you paid for it. You may have to pay the lender out of pocket to cover the difference and discharge the mortgage – yikes. 

There are a few ways negative equity happens. The two main reasons borrowers slide into negative equity are:

• Their home value plummets.
• Their home loan deposit was too small. 

Usually, it’s a combination of these two factors that creates negative equity. It all goes back to the basic equity equation:

Home equity ($) = Home value – loan value

If your home loses too much value and your loan value isn’t shrinking fast enough, your equity becomes negative. 

Negative equity example

Chico buys a house in an underperforming neighbourhood with a 5% home loan deposit worth $25,000. This means he starts out with only $25k in equity. His home is worth $500,000, and his loan is worth $475,000.

$25,000 = $500,000 – $475,000

However, a recession hits and the property market in his suburb has a downturn. His home is now only worth $400,000. Therefore, Chico’s new home equity is -$75,000.

- $75,000 = $400,000 – $475,000

If he decides to sell immediately, this is how much money he would have to pay his mortgage lender.

Home equity increases as you pay down your mortgage or when the value of your home increases. This is useful whether you want to grow your nest egg or get out of negative equity.

The main three ways to increase your home equity are:

• Make extra mortgage repayments to pay off your mortgage faster.
• Improve your home value, such as through renovations or adding green features.
• Increase the size of your initial mortgage deposit. 

If you’re just starting your mortgage, your home loan deposit is the main factor determining your home equity. This is because your home loan deposit is the dollar amount of the loan you will own from the outside. If you pay a 20% down payment, you have 20% equity in the property. 

Having a larger deposit (as high as 40%) not only increases your equity but could make you eligible for lower home loan interest rates, since lenders don’t see you as a risky investment. 

HOT TIP: It’s also possible that rising housing market prices will boost your home equity for you – historically, data shows house prices generally rise over time in Australia anyway.

Ready to move home loans? Compare refinancing rates and offers in the table below.