Any significant expense that is unplanned and cannot in the normal course be facilitated by regular savings can be accommodated by equity financing. Such facilities allow for immediate funding of the expense with ample time for repayment over an extended period, lessening the impact on disposable income.
A home can also be leveraged as a source of further wealth creation. As far as possible, home equity financing should be utilised to improve long-term wealth. For this reason, it is most often utilised to improve the value of the property or to improve the long-term financial circumstances of the customer. Investments of such funds are geared towards creating further wealth.
Home Equity Explained
A home is a significant investment, as it generates wealth as an appreciating asset. Moreover, it also provides the homeowner with equity. Equity is simply the difference between the market value of a property, and the outstanding mortgage balance.
Facilities are provided to increase the debt on the property based on current market value, as opposed to the original cost that may have been the basis of funding upon initial purchase or construction. Referred to as a home equity loan, access to this facility is dependent on your current needs and existing financial circumstances. A home equity loan is generally secured by way of a second mortgage on the property. However, depending on the interest rate and/or outstanding repayment term of the existing mortgage, the homeowner may opt to refinance the existing balance and increase the amount of the total outstanding debt.
Homeowners, some of whom have only owned their homes for as little as 3 to 5 years, may have fast accumulated incremental value known as equity in their homes. It stands to reason, therefore, that the level of home equity that is currently being enjoyed by homeowners whose mortgage loans have been repaid by as much as 50% or more, represents significant wealth in terms of their equity in the existing property. Bear in mind, however, that this equity only translates into cash if the homeowner decides to sell the house or access an Equity Loan.
There are those who may argue that this is the only purpose for which a home equity loan should be obtained. This is on the premise however, that the purpose of the loan is to undertake a project, as opposed to general home repair, that will enhance the value of the property by an amount that exceeds the cost of making the improvement(s). Such projects may include adding a swimming pool, installing an electronic gate, or enclosing the property with fencing. Due to the amount by which these projects may increase the market value of the property, they may serve to elevate the home equity in some instances, by as much as twice the cost of actually undertaking the project.
Where the rate of return on a low risk, long-term investment such as an annuity, is higher than the cost of incremental funds on a mortgage facility, such investments may be financed by an equity loan on a property. High-risk investments such as stocks and shares are not advised. The important factor to consider when deciding on home equity financing for investment purposes, is whether the rate of return on the proposed investment is higher than the rate of interest being paid on the mortgage loan. The investment should carry similar risk and ensure preservation of capital, which is the amount originally invested. Fluctuating investments should be avoided. Long-term investment options could also include the purchase of a property for rental purposes.
This may be the most common purpose for which home equity loans are considered, and has become a significant marketing strategy for many mortgage financiers. While it is preferable that home equity be used to generate wealth and increase one’s asset base, the decision to use home equity for the purpose of debt consolidation makes sense particularly where high cost debt like credit card debt is repaid, allowing for improved cash flows and increased savings.
Education & Medical Expenses
Equity financing can be used to accommodate any significant unplanned expense that cannot be facilitated by regular savings. Such facilities allow for immediate funding of the expense with ample time for repayment over an extended period, lessening the impact on disposable income. The return on this investment, however, is more long term in nature, in that having achieved the objective, the results/returns may not be immediately forthcoming.
Avoid Luxury Purchases with a Home Equity Loan
Home equity loans should not be used for what can be described as a “luxury purchase” such as a lavish vacation. In such cases, the debt continues long after the “returns” are reaped. Long-term debt should only be used to fund long-term assets and/or long-term needs that will provide a return on the investment. With regard to expenses such as medical or other family emergencies, these decisions must be carefully assessed on a case-by-case basis.