Home equity is essentially the current market value of your home/property after any debts that remain to be paid for it (like your mortgage) have been subtracted. If you're planning to use the equity in your home, there are smart moves and there are bad moves. Here is some good info to help you make the smart ones.
There are two ways you can borrow against your property; a Home Equity Loan (HEL) or a Home Equity Line of Credit (HELOC). The question is: which is the right one for you and your particular financial situation.
Smart Move #1: Choose Wisely
What is a Home Equity Loan (HEL)?
A home equity loan allows you to borrow money in one lump sum, using your home's equity as collateral, and pay it back over a fixed term at a fixed interest rate (like a mortgage or car loan). Home equity loans are often referred to as a second mortgage because they are secured by your property just like the original mortgage. Your maximum loan amount is determined by how much equity you have in your home. Equity is calculated by determining the difference between how much the home is worth (current market value) and how much you owe on the current mortgage.
The Home Equity Loan is good for:
The HEL is good for people who want money for a one-time event, and prefer the security of fixed-rate loans. This is a good option if you want to keep your existing mortgage and prefer to receive the cash in a lump sum.
What is a Home Equity Line of Credit (HELOC)?
A HELOC works like a credit card. It makes a certain amount of credit available on an as-needed basis for a limited term, such as five or 10 years, followed by a repayment period of up to 20 years. It has an adjustable rate that changes with the market. A HELOC might make sense for you if you need to borrow smaller amounts over a longer period. HELOCs typically have lower interest rates but since interest rates have almost nowhere to go but up, the variable interest rate could end up costing you more in the long run.
A HELOC is good for:
A HELOC is good for people who need access to a reserve of cash over a period of time. For example, during a remodel you can withdraw cash periodically to pay contractors. HELOCs provide the flexibility of having access to cash, but not paying interest until you actually withdraw it.
HELOCs have another significant drawback. Lenders can freeze or reduce your line of credit without warning if they learn of a change in your financial circumstances or a drop in your home's value. That means you can't always count on a HELOC to be there when you want to use it.
For either option, you'll need to provide full documentation of income and assets. Your lender may or may not require an on-site appraisal, depending on how much you want to borrow and other factors.
To get the best interest rates with most lenders, you'll need a credit score of at least 740.
Lenders typically add the value of the home equity loan or line of credit you're seeking to the balance of your primary mortgage to see if you'll retain at least 10% to 30% equity in the property. That means if your home appraises for $300,000 and the balance on your primary mortgage is $200,000, you could borrow up to $70,000 with a home equity loan or line of credit and still retain 10% equity, or $30,000.
If not, your application for a second mortgage will be turned down.
Smart Move #2: Know as much as you can about these loans and how they work
Whichever type of financing you choose, home equity rates are very attractive right now.
Since home equity loans have a fixed interest rate and term, this monthly payment calculator can figure out your repayment plan. Whereas HELOCs are more difficult to predict because the interest rate changes over time and they usually offer some flexibility in how you repay them.
Most HELOCs require low, interest-only minimum payments for the first 10 years while the line of credit is open to use. But in the 11th year, the line of credit is closed, and the principal must be repaid over the next 10 to 20 years.
Experian says the typical minimum payment is almost 70% higher for borrowers who are beginning to repay the balance on their HELOCs this year. A better option is to pay back the loan quickly to minimize the amount you pay in interest, get rid of the monthly payment and eliminate the risk of having your home as collateral for a secondary purchase.
Smart Move #3: Limit the use of your equity
During the housing bubble, consumers used home equity borrowing to pay for everything from boats and gambling junkets (clearly bad) to cars and kitchen renovations (not so bad). The problems these homeowners experienced during the financial crisis and recession taught us that even some "not so bad" spending should be scratched from our list of acceptable uses. So while financing a car with a HELOC was at one time OK, that is no longer the case. Besides, auto loans are now one of the few types of consumer loans that are cheaper than home equity loans or lines of credit.
Ditto for discretionary home-remodeling projects.
Savings is really the only prudent way to pay for renovations such as updating a kitchen or bathroom. Home improvements will boost the market value of your home. But contrary to what you see on television, you will recoup only a portion of any project's cost. For every $100 you spend, your property value will only increase by $70 to $80, maybe less.
Now, if you lack the cash to make essential repairs that your family's safety or your home's structural integrity depend on, then home equity borrowing makes sense. We're talking about fixing things such as a worn-out roof that's leaking and causing water damage or faulty wiring that can start a fire.
With rising college tuition and borrowing costs, you might be tempted to use home equity to pay for your child's tuition. The interest rates can be lower than those on student loans, especially private student loans and PLUS loans.
A cash-out refinancing on your first mortgage could be even less expensive, since first mortgage rates are below home equity loan rates. You'll need to compare the interest rates and closing costs to see which option is cheaper.
And if you're considering putting part of a semester's tuition on a credit card and carrying a balance, using a HELOC to manage short-term cash flow is a much better option.
Smart Move #4: Use your equity to cut interest payments
Finally, it still makes sense to use a home equity line to pay off all of your high-interest credit cards and repay that debt at the home equity line's lower interest rate.
You'll get out of debt faster by taking all (or at least most) of the money you needed to keep up with your credit card bills each month and sending it to your home equity lender instead. Of course, you must refrain from running up big balances on your credit cards again (remember, we talked about this in February), or you'll defeat the whole purpose of the home equity line. A debt consolidation calculator shows how much you can save and how quickly you can become debt-free.