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Home equity is an indispensable financial resource for homeowners. As a starting point, let’s define “home equity.”
Equity is the value of the home minus the mortgage loan.
Home equity refers to the amount of equity you own in a home as opposed to the lender’s interest.
Your home equity is the difference between the appraised value and the outstanding mortgage balance on your home. Suppose you own an $800,000 property with a $300,000 loan, so your equity is $500,000.
In general, you will increase your equity as you pay off your mortgage, upgrade your house, or increase its value over time.
Even though your debt profile may have remained static, your home may have increased in value (perhaps due to home improvements).
The good news is that you don’t have to sell your house or take out expensive loans to access it.
Homeowners can use additional equity to release cash. To access their equity, they can take out a home equity loan, a home equity line of credit (HELOC), or a cash-out refinance.
Borrowing against your home equity
Getting cash from home equity is not a very straightforward process. Your equity must be calculated based on the market value of your property.
Note that a home appraisal is not a guarantee of a sale, although it may indicate a price.
It is, however, possible to obtain low-cost funds through your home equity. A few examples follow.
A home equity loan, also known as a second mortgage involves borrowing money and repaying it over time.
As with a primary mortgage, an equity loan begins with an interest payment and a principal payment. A loan that has already been issued cannot be redrawn.
Home loans of this type have a structure similar to primary mortgages. However, the home equity loan interest rate is typically higher compared to a primary mortgage. This is because, in case of a foreclosure, home equity lenders would have to repay the principal first, increasing their risk.
Home equity loan requirements
A home equity loan has more requirements than a mortgage loan. While lenders will follow different rules depending on the type of loan, most follow the following:
1. Debt-to-income ratio:
The debt-to-income (DTI) ratio is a measure of how much debt you owe compared with your income. Calculate your DTI ratio by adding up all your loan payments and dividing them by your gross monthly income.
A home equity loan typically requires a DTI ratio under 43% once your potential new loan payment is calculated.
To reduce your debt-to-income ratio, you can either pay down your debt or raise your earnings.
2. Credit score:
For most home equity loans, lenders require a minimum credit score of 620 – although in some cases, the limit can reach 660 or 680. While this is true, A poor credit history does not necessarily prevent you from qualifying for a home equity loan.
3. Home equity:
A home equity loan must have a certain amount of equity. When taking out a home equity loan, you might be able to borrow more money if you have more equity than you can from many lenders.
An LTV ratio represents how much equity a home has based on its debt-to-value ratio. Suppose your house is worth $250,000 with a mortgage of $200,000, giving you an LTV ratio of 80% and 20% equity.
Many lenders will go above the minimum equity requirement for a mortgage loan, which is typically 15% (85% LTV). Lenders are advised to require mortgage insurance if the LTV exceeds 90%.
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Home Equity Line of Credit
A home equity line of credit (HELOC) is the easiest to get. In a recursive second mortgage, you borrow only what you need, pay it off, and borrow again.
Your payment depends on the amount of credit you use rather than the loan amount. You can easily access funds with most lines of credit using a checkbook or debit card.
HELOCs usually don’t have closing costs compared to second mortgages and second loans.
Moreover, HELOC rates are flexible, meaning they are subject to prime rate fluctuations. Often, home equity loans start at a discounted rate and then increase over time.
HELOCs have two phases: initially drawing down the funds, and then repaying them.
Draw periods are typically five to ten years long. This timeframe allows you to withdraw up to your credit line and pay only interest.
After you withdraw the final amount, it becomes a loan you must pay back with interest (usually between 10 and 20 years). During this time, you will not be able to draw on the account.
The most important benefit of a HELOC is that you only pay interest on the outstanding balance.
For instance, your child needs $35,000 over three years to pay for college. As the balance of your home equity line of credit grows, you will be required to make higher payments. By contrast, a one-time loan would require immediate repayment of interest.
What you can do with your home equity
1. Invest your equity in real estate
It is one of the more well-known uses of equity. When buying an investment property, you can use your equity instead of putting down a deposit (or selling your home).
Your lender will order a valuation to determine your property’s fair market value. Using this valuation, you will be able to figure out your equity percentage.
In theory, simply owning $250,000 does not give you access to that equity. Besides income, lenders also consider the number of children you have, your general living expenses, and any debt you may have.
Assuming that your equity is serviceable, you could receive $160,000, or about 80% of your equity.
2. Make a cash-out refinance on your existing loan
A cash-out refinance lets you refinance with a larger mortgage while receiving additional funds from the lender.
The money can be used for debt consolidation, home renovations, and car loan repayment.
In most cases, cash-out loans are limited to 80% of the house’s value. The advantage of a cash-out refinance is that it is a direct mortgage loan, not a second lien or line of credit, which allows for a lower interest rate.
3. Invest your equity in other areas
The fact that you have equity in a property doesn’t mean you have to keep it there.
If you want to get the most out of your equity, you may want to consider diversifying.
In a broader sense, this is what wealth creation is all about. Use your home equity for more than just property investing. Fund your next renovation project, consolidate your debt, or fund your education with your equity.
You can use your home equity as collateral for a variety of expenses, including debt consolidation, tuition, and renovations.
However, you must keep in mind that taxpayers can only deduct interest on loans used to buy, build, renovate, or extend a residence.
HELOCs usually require 10% equity (or 20% equity in an investment property or second residence). If you opt for this option, you’ll have to pay back any loans you take out, plus interest.
Takeaway
Homeownership is thrilling, but long-term ownership will help you weather any market fluctuations and cover any selling costs that arise.
- Home equity loans and HELOCs provide excellent financing options for home improvement projects and debt consolidation.
- Mortgage loans have lower interest rates than credit cards or personal loans without collateral.
- There is no one size fits all solution for home equity financing.
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- HELOCs usually have lower interest rates, which allows for greater flexibility, but a home equity loan may be more appropriate for large purchases.
- A home equity loan allows you to make a one-time payment, but with a higher interest rate. HELOCs, however, give you easy access to cash when you need it, but rates can change over time.
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Consider the purpose of the loan as one of your guiding factors.
How do you plan on paying for future renovations? Are you planning on borrowing the money and paying for it all at once?
Check around and ask lots of questions to get the right financing at the right interest rate.
If you’d like to get our opinion on your specific situation, call us directly at (617)729-2967 or click here.
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