If you believe everything you see on television, home equity is a wondrous pool of never-ending money that allows you to do and have everything you want in life — take your dream trip, pay for college, remodel your kitchen or buy a vacation home in the Caribbean.
Luckily, most of us have learned to take what’s on TV with a grain of salt and abide by that age-old adage, “If it sounds too good to be true, it probably is.” In this article we’ll clear up some misconceptions about home equity loans and why you might consider one in the first place.
Another loan, really?
There are many smart reasons for taking a home equity loan, but you’re right to be cautious. Ideally, you want to use the funds you borrow against your home to be useful in helping you accumulate more wealth in the long run.
- Home improvements — This is one of the most common reasons homeowners leverage the equity in their homes. The right home improvements can help raise the value of your home, making it worth more when you sell it down the road.
- Debt consolidation — Home equity loans generally have a lower interest rate than credit cards or personal loans, so you may choose to consolidate your debt and save money in the long run.
- Medical bills — Because of the lower interest rate, using the equity in your home to pay off emergency medical bills may be a better way to go than using high-interest rate credit cards.
Equity equals value
The definition of equity is “value or worth.” Home equity is the value or worth you have in your home. You can calculate that as the value of your home minus what you owe; so, if your home is worth $150,000 and you owe $100,000 on your home, you have $50,000 in equity in your home. So that means you can get a home equity loan for $50,000? Nope. Still too good to be true.
Remember that down payment you made when you bought your home? A down payment is a lump sum of money that is initially paid when you finance a home, and it’s generally excluded when calculating the equity for a home equity loan. For a mortgage, a typical down payment runs anywhere between three and 20 percent of the cost of the home. The reason banks require a down payment is twofold: 1) to make sure you have some skin in the game, and 2) to protect the bank’s investment if the house’s value decreases when you go to sell it.
The bank may not be willing to loan you 100 percent of the equity in your home, so the amount of money available to you will depend on the value of your house today, the amount you still owe on your original mortgage, and the terms of the new home equity loan. Generally, the finance charges to borrow 100 percent of the equity in your home will be higher than finance charges on a loan where you are only borrowing up to 80 percent of the equity in your home.
How much is your house worth today?
This is something the bank won’t just take your word on. Home values, home improvements and local real estate trends all impact the value of your home today, and it is a value that can change frequently over time.
Before a bank issues any sort of home equity product, they’ll order an assessment or appraisal of your home, which may include an in-home visit, property inspection and comparative analysis of similar homes on the market.
If you are planning to sell your home soon, the assessment can be helpful, but that means it’s probably not the time to take out a home equity loan. All loans against your home must be paid off in full before you can sell, so if the sale price of your home doesn’t cover amount of the loans, the mortgages won’t be removed, and you could end up in a foreclosure situation.
Home equity loan vs. home equity line of credit
There are generally two ways you can borrow against the equity in your home: a home equity loan or a home equity line of credit (HELOC).
A home equity loan is similar to a car loan or even your original mortgage. You receive all the money you need in one lump sum and you pay it back with a fixed interest rate through set monthly payments for the life, or term, of the loan.
A HELOC is a little different. With this type of financing, you receive access to a specific amount of money, but you only borrow the money as you need it. For example, if you open a line of credit for $15,000, but you only use $5,000 to pay off emergency medical bills, the remainder of the line is there should another emergency or necessary purchase come up. Since you only used $5,000, you only pay finance charges on the amount you borrowed. This type of financing generally has a variable interest rate, and you’ll need to be disciplined to not tap into the money unnecessarily.
Making the decision to use your home equity isn’t inherently good or bad, just like making the decision to charge items to a credit card. Good investments can take a variety of forms based on your personal situation.
What is important to remember for your financial health is to not borrow more money than you need and not spend more than you can afford to pay back. Stick to a solid strategy, and you’ll enjoy the benefits of your financial investments for years to come.