Buying a home is likely to be the largest purchase you ever make and homeownership offers certain financial fringe benefits.
One of those financial benefits is the equity you build as you pay down your mortgage.
Equity is the difference between the home’s fair market value and the amount you owe on the mortgage. If, for example, your home is worth $250,000 and you owe $150,000 on the mortgage, you have $100,000 worth of equity. Through the first quarter of 2017, approximately 13.7 million homeowners in the U.S. had more than 50 percent equity in their homes.
Negative equity is figured with the same equation. If your home is worth $250,000 and you owe $300,000, you have $50,000 in negative equity. You owe more than the home is worth.
Other terms for negative equity are “underwater” and “upside down.”
If you’ve got positive equity you can sell your home for market value and walk away in the black.
You can also borrow against your equity, or use it to secure a line of credit, to fund other needs. Ways homeowners leverage equity include:
- To make home repairs or renovations
- To consolidate other debt
- To purchase another property
- To pay for a large unexpected expense
Borrowing against your home equity comes with advantages and disadvantages, just like any other financial decision. Know how the pros and cons balance out before heading to the bank.
Home equity loans vs. home equity lines of credit
You can access equity (without selling) in two ways. One is to take a home equity loan; the other is to get a home equity line of credit, also known as a HELOC. They sound similar but have important differences that you need to understand.
Home equity loan basics
A home equity loan is a second mortgage. It takes a backseat to the primary mortgage. Like your primary mortgage, the home equity loan is secured by the home itself. Depending on the lender, you may be able to borrow up to 85 percent of the equity you have in the property.
When you apply for a home equity loan, you’re applying for a lump sum of cash. Like mortgage loans or student loans, home equity loans are installment debt, meaning the monthly payment amount and length of loan are set and do not change. You make the payments each month until the loan is fully repaid. Use an online home equity loan calculator to ballpark the payment for the amount you want to borrow and make sure it’s affordable.
Home equity lenders charge interest. Your rate is based in part on your credit score. Credit Sesame did a round-up of the best home equity loan rates last year and found that with some lenders, the rates for home equity loans were lower than the rates for conventional mortgage loans.
Home equity loans are typically fixed rate loans. That means your APR and required payment will not change over time. Also, you’ll know up front exactly how much the loan will cost. For qualifying borrowers, the interest paid on a home equity loan is tax-deductible, like the interest on a primary mortgage loan.
Depending on the lender, you may or may not pay an application or loan origination fee for a home equity loan. The closing costs are similar to those associated with a primary mortgage. Closing costs often run between two and five percent of the loan amount, and some lenders allow the borrower to roll these costs into the loan. If you do roll closing costs into the loan, you will pay interest on those costs for the life of the loan. Your lender may also give you the option to purchase points to get a lower interest rate.
How a HELOC works
A home equity line of credit (HELOC) is also a second mortgage – it is secured by your home. Unlike a home equity loan, a HELOC works like a credit card. Instead of getting a lump sum of cash you get a line of credit that you can draw against as needed. A HELOC is revolving debt. You can make additional draws as you pay the balance down and increase your available credit.
Generally, the guidelines for how much you can borrow are similar to those for a home equity loan. Lenders typically cap a HELOC at 85 percent of your equity value.
Interest rates on HELOCs are typically variable. Variable rates are tied to an index rate, such as the Prime rate. As the index rate goes up or down, the rate on your HELOC will soon follow suit.
You can’t draw against your equity indefinitely with a HELOC. Your lender will define a period of time during which you can access your HELOC. The draw period is usually between five and 10 years. Once the draw period ends, you enter the repayment period, which may last for 10 or 20 years, depending on the size and terms of your HELOC.
During the draw period, some lenders allow you to make interest-only payments to your HELOC. When the regular repayment period begins, you’ll have to make payments against the principal and the interest. If you paid only the interest during the draw period, your monthly payments could be larger than they would have been if you opted for a home equity loan instead. The interest on a HELOC is tax-deductible if you use your line of credit for something that’s related to the home, such as putting on a new roof or completing a large-scale renovation.
Once your repayment period begins, it’s a good idea to research current fixed rate home equity loans to see if you can save money as you pay the balance down.
When does it make sense to borrow against your equity?
Ultimately, whether it’s a good idea to borrow against your home depends on what you want the money for, how much you can borrow and what the associated interest rates are for a home equity loan or HELOC.
If you have credit card debt at high interest rates, and especially if you’re struggling to keep up with all of the minimum payments or you don’t seem to be making any headway against the balances, a home equity loan or HELOC can provide some relief with a lower rate and extended repayment period.
Private student loan debt
If you have private student loan debt at double-digit interest rates and you can qualify for a six percent APR on a home equity loan or HELOC, leveraging your equity to pay off the student loans could save you money over the long term.
Home equity loans and HELOCs can also be useful in situations where you need access to a large amount of cash but you don’t want to drain your emergency fund. For example, let’s say your roof springs a leak and the cost to fix it is $20,000. Instead of using up all your cash reserves, you could use your home equity to finance the repair and pay for it over time.
The same is true if you get hit with a big tax bill from the IRS. Interest and penalties on the unpaid tax bill might exceed the cost of a home equity loan or line of credit.
On the other hand, there are times when a home equity loan or HELOC wouldn’t necessarily be the best choice.
You might be thinking of leveraging your home equity to pay for a vacation but there are plenty of travel rewards credit cards that could be a better fit. With a rewards credit card, you could earn points or miles on your travel purchases and some cards offer added perks like free checked bags or discounted companion tickets. You won’t get those benefits with a home equity loan.
Buying a car with a home equity loan doesn’t make sense since a car is a depreciating asset. In other words, you’d be making a negative investment with the money. On the other hand, using a home equity loan to make physical improvements to the property could raise your home’s value. Not only that, if you’ve got great credit you may qualify for an interest rate on a car loan that is much lower than the rate a lender offers you for a home equity loan.
Downsides to leveraging your home equity
Home equity loans and HELOCs are tied directly to your property. If, for some reason, you’re not able to keep up with the payments and you end up in default, you risk losing your home. The lender can initiate foreclosure proceedings even if you’re current on your first mortgage. Be sure you’re financially stable enough to manage the payments on both your primary mortgage and your home equity loan or HELOC or you jeopardize your home.
Also, if you refinance a debt with a shorter repayment period to a longer one, you might increase the overall cost of your debt.
Take advantage of Credit Sesame’s tools if you’re considering a home equity loan
As they will for any loan, lenders will examine your credit rating when you apply for a home equity loan or HELOC. Check your credit report and score before you start filling out the loan paperwork to ensure that there are no surprises.
When you log in to your member dashboard, you’ll see letter grades corresponding to how well you’re doing in each of the factors that affect your score:
- Payment history
- Credit usage
- Credit age
- Account mix
- Credit inquiries
For instance, if you have a ‘C’ for credit usage, you will see a suggestion to pay down some of your credit card balances to improve your standing.
Check your Credit Sesame member dashboard before you apply for a loan so that you’ll know how likely you are to qualify and what you can do to improve your score to put yourself in better condition for approval at good terms.
You can also use your dashboard to calculate your debt-to-income ratio. This ratio shows how much of your total income is spent on debt each month (using required minimum monthly payments). You can enter your annual income manually, and the debt-to-income ratio is automatically calculated.
If you’ve checked your debt-to-income ratio and it’s above 43 percent, spend some time paying down your debts or increasing your income before you apply for a home equity loan or line of credit. One strategy to make faster headway against debt is to transfer some high interest balances to a credit card with a zero percent introductory interest rate.
Check under the My Recommendations tab in your dashboard to find offers for low interest balance transfer credit cards or personal loans.