A home equity loan can be a great option for homeowners who need quick access to cash, but of course, you have to be mindful of how you’re using your home equity, because it can be risky to get into any sort of leverage.
There are several smart uses, such as for home renovations, debt consolidation, and to keep in case of emergencies.
There are risks associated with securing your home for a loan that borrowers need to fully consider.
What is Equity in Your Home?
Home equity is simply the amount of your home that you own.
If your house is valued at $200,000 and you have no debt on it, then you have $200,000 of equity in your home.
Let’s say your home is valued at $200,000 but you have a $125,000 mortgage, then you have $75,000 of equity. It is the difference in the home’s appraised value and what you still owe.
The equity in your home should grow over time but isn’t a guarantee. Every mortgage payment you make reduces your principal balance owed, increasing your home equity. Equity can also increase if your home’s value appreciates.
A study by Black Knight, Inc. reported that the annual rate of appreciation for homes in the US is 3.8%.
How to Access Your Home’s Equity?
You don’t have to sell your home in order to access the equity. There are a few common ways to gain access while you still live in the house.
Home Equity Line of Credit (HELOC)
A HELOC is similar to a credit card, but with your house as collateral. It’s a revolving line of credit, meaning you can use funds and repay them as needed. The rate is variable and can go up and down. HELOC’s will usually have a lower interest rate than home equity loans.
The terms can vary, although you’ll usually have 10 years to borrow, followed by a repayment period that lasts from 10-20 years. Your monthly payments tend to be interest-only for the first 10-year draw period, then are principal plus interest for the repayment period.
Home Equity Loan
Home equity loans are a fixed interest rate option that can have terms from 1-15 years. The loan proceeds are distributed when you close, unlike the HELOC where you can draw when needed.
This option involves refinancing any debt you currently have on your property, but the new loan is more than you owe. Those additional funds are from the equity you’ve built up. This tends to be a good option if you’re able to lower your current mortgage rate. If refinancing causes the rate to increase, it’s not a good option.
The process will start by finding an appropriate lender, such as a bank. The banker will be able to provide the terms and general underwriting criteria.
Loan to Value (LTV)
The loan to value determines how much the bank will be willing to lend. The first step is getting the home appraised to determine the current market value. The lender will then take the appraised value and lend up to a certain percentage, 80% for example.
Let’s say your house appraises for $200,000. If the bank is willing to lend up to 80% of that value, that equates to $160,000. If you have any debt on the property, you’ll have to subtract that debt from $160,000. If you have a mortgage of $100,000, the most the bank would be willing to lend is $60,000.
Debt to Income (DTI)
Debt to income is a formula used to see how much debt you have compared to your income. Typically, the highest DTI allowed is 40-45%.
If your gross income is $4,000 every month, the lender will want to see your monthly obligations (debt payments) be less than $1,600. That includes the new loan, and for HELOC’s they will assume the line is fully drawn for underwriting purposes.
A borrower’s credit score is an important factor with home equity loans. The minimum credit score will differ from place to place, but 620-650 is usually the minimum score needed.
Your credit score will affect pricing, with the best rates going to those who have a score of 750 or higher.
Great Uses for the Equity in Your Home
The use of your home equity loan is not normally limited by the lender. They certainly will ask and if debts are too high, they may require you to use the line to pay certain loans off.
Just because the lender doesn’t care, does not mean you shouldn’t. There are risks to using your home as collateral that home owners need to fully understand.
1. Improving your Home
Using your home equity loan for home improvements is a great option and one of the most common uses. It’s also a way to get possible tax benefits with the interest paid, but it’s best to speak to your accountant to determine.
It’s a great emergency tool to have in place in case any home repairs are needed. Not only is it helpful if you’re cash strapped and need an urgent repair, but depending on the issue, it could improve the value of your home.
Larger home renovations are another excellent use of a HELOC. Kitchens, bathrooms, patios, roofs, and basements are all projects that yield a good return on investment.
2. Debt Consolidation
Paying off higher interest debt with your lower interest home equity line can save you a lot of money.
Credit card debt, car loans, boat loans, and really any personal or business loans that charge a higher rate than the home equity loan.
It is important to think long and hard about moving your debt, especially if it’s unsecured, to a home equity loan. The fact is you’re pledging your house as collateral and if anything goes wrong, that can spell trouble.
3. Student Loans
Home equity loans can be a suitable option to pay for your or your kid’s college education. Student loans tend to have higher interest rates, which makes using your home equity attractive.
Home equity loans and mortgages will also let you stretch your payment over a longer period, such as 15 or 30 years. It’s best not to stretch your student loans out that long but is an option if needed.
Student loans are unsecured and defaulting on this type of debt will hurt your credit but is better than defaulting on a home equity loan or mortgage. Failing to pay a debt that’s secured by your home could result in you losing your house.
4. Other Real Estate
Home equity loans can be a great way to purchase other real estate. Let’s say you’re moving and plan to use proceeds from the sale of your current house to pay for the new home.
Generally, you’d need to add a mortgage contingency to the purchase contract for the new home.
You can use the home equity loan to place a down payment on the new property. If you’re downsizing and have enough equity built up, you can use the loan to pay for the new home in full. This would be considered a cash offer and may give you more negotiating power when searching for your home.
When you sell your old home the proceeds then pay off your home equity loan. This is a riskier move if you cannot sell your old home, so tread lightly.
Your home equity loan can also be used for down payments on second properties, vacation homes, and even rental properties which are a great way to build wealth.
5. Unexpected Expenses
Not using your home equity loan is probably one of the best uses I can think of. Having a HELOC in place and available for any emergency or unexpected expenses is a great plan.
Some common unexpected expenses are:
- Medical Bills
- Car Repairs
- Pet Emergencies
- Home Repairs
- Family Emergencies
- Income Taxes
While a home equity line of credit is perfect for these types of unexpected expenses, you still need to have a plan in place to repay these sorts of expenditures. That’s where your emergency fund comes in. It’s vital to set up, contribute, and maintain your emergency fund even if you have a HELOC in place.
There’s a lot of great reasons to use home equity loans to enhance your financial picture. It’s also important to consider some of the risks.
Pledge on your home
Home equity loans are secured by a pledge on your house. If you default on your loan, you could lose your home. Make sure you have a plan to repay what you borrow.
It can be tempting to consolidate debt with your home equity loan but be prudent if that debt is moving from unsecured to secured debt.
If you choose the home equity line of credit option, be aware that it has a variable rate. The good news is most lenders have a ceiling rate, meaning it cannot go above a certain rate. The bad news is, that ceiling is usually close to 20%.
HELOC’s are best used for shorter-term lending needs with the ultimate repayment coming within 1-3 years.
There’s plenty of good reasons to use a home equity loan. There’s also plenty of poor uses as well. Be prudent when borrowing and be sure to have a repayment plan that’s viable. Don’t let a large commitment tempt you to make unwise financial decisions.
About the Author:
This article is by Paul, finance expert and founder of The Income Finder. With over 15 years of experience in the finance industry, a bachelors from Benedictine University and an MBA from DePaul, he’s well qualified and ready to share great insight and tips on money management.