Reduce interest

Use your equity

The other day a friend asked me to help her with a personal loan to pay for her upcoming wedding. She applied for a personal loan with one of the major bank. The loan was approved and the rate offered was something like 14%. My friend was happy to accept the rate but the bank wouldn’t release the money because they wanted receipts to prove that she is spending the money on the wedding! The bank wouldn’t just give her the cash. Very frustrating when you’re planning a wedding! She asked me what she can do to get the cash without having to go through with all the trouble of receipts and bank cheques.

I asked her, “what about your home loan?” how much is your house worth and how much debts do you still owe? As it turned out, she has some equity in her home that she could use to get extra cash at a cheaper rate.

What is equity?

Equity is assets less liabilities, in the case of a property, it’s the value of the property less the debts secured by that property. In my friend’s example above, her house was valued at $330K and her home loan was $220K. That means her equity in the house was $110K, however banks normally only lend up to 80%, therefore $330K becomes $264K, that’s the maximum the bank would lend against a property without making you pay lender mortgage insurance. You can borrow higher than 80% of the value of the property, but in most cases you will have to pay mortgage insurance.

As you can see, my friend only owe $220K, the bank was willing to lend up to $264K against her house provided that her income can service the debt. She got an extra $44K up her sleeves should she needs it, well she does needs it.

Instead of taking out a personal loan at 14% and go through all the complications that most banks would impose with a personal loan. I told her to go see her bank about an increase on her home loan to pay for the wedding, which is perfectly fine from the bank’s point of view. The bank is much happier to approve it because they have security and they will be able to offer home loan rates as well. Much cheaper and no hassle with receipts, they will just transfer the money into her saving account when the loan is drawn.

This principle can be use in any situation where you need a bit of cash or consolidate your debts. If you got an outstanding credit card debt or a car loan that’s on a much higher interest rate, why not increase your home loan against your equity to pay off the higher interest debts. You don’t necessarily have to increase the home loan, you can leave your home loan the way it is, just get a new loan secured by the same property to keep it separate (eg. if you need to keep it separate for tax reasons).

The whole idea is if you need to borrow, then borrow at the lowest rate possible. Debt is debt, whether your house is collateral or not, if you’re worrying about linking your house to the debt and risk losing it in case you’re in default, then you shouldn’t borrow. Only borrow if you’re absolutely sure that you can service the debt.

The equity is yours why not take advantage of it. It makes much more sense to go for the lowest interest rate possible. Some people think, “but I want to pay off my home loan faster”, well yes you will pay off your home loan even faster if you minimise your overall interest costs, no point having no debts on your home and have all these credit card or personal loan debts outstanding at high interest rate.