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If you are planning on buying a house, or you maybe already bought one, you have probably been introduced to a whole world of new terms and possibilities. This can be rather overwhelming, especially when everyone assumes that you are already closely familiar with what it all means, how it works, and alike.
Home equity is one such term that carries a lot of meaning and possibility with it, and if you are unsure of what it means, how it works, how to build it, calculate it, use it, and more — you have come to the right place, as that is what we will explain in detail today.
Home equity: What is it?
For most people, cashing out the money for a house or other kind of property in this day and age rarely comes from their own pocket, and they have to take out a loan, which they then have to pay back. Home equity is the portion of the property that you have already paid off, and it now officially belongs to you.
In other words, you can think of it as your stake in the property, as opposed to the lender’s. In more technical terms, it is the appraised value of the home minus the outstanding loan balances and mortgage. What remains is yours, and it is what we call home equity.
Now, usually, home equity gets built up over time as you continue to add value to the home, pay out your mortgage balances, and alike. Over time, it will become the most valuable asset that most homeowners possess, as it can be used to get a line of credit or borrow home equity loans. With that said, it is in your best interest to build home equity as much as possible, and make your most valuable asset as valuable as it can possibly get.
How can you build home equity?
There are several ways in which you can increase home equity. This is possible because it represents the difference between the home’s market value and the mortgage balance, so by doing several different things, you can effectively boost its value. For example, home equity can grow when:
1) The value of property goes up
Property value usually increases over time. There are also instances when it drops, usually unexpectedly, but those happen far less often than the value increase. This is known as appreciation, and it is a good way to build home equity. This includes a number of factors, and not all of them are under your control. For example, the state of the economy, and the location of property can play a large role. Historical price data for your area can give you more insight into how the value of property behaves over time in that region.
2) You make a larger down payment
A down payment is an amount that you deposit when taking out a loan, and it can have a number of positive effects, including increasing the equity in your home. If your down payment is 15% or even 20% of the value of the home, your equity would be much higher than it would be if you could only put 10% as your down payment. Not only that, but if you need another loan, 20% could often help you get it faster, as most lenders will require at least 20% equity in your home before they approve your application.
3) You make mortgage payments
Your home equity will also go up automatically by reducing the outstanding balance on the mortgage you took. In other words, as you continue to make payments, the amount that you owe continues to shrink while your ownership of the home continues to grow. And with it, home equity continues to increase as well.
4) You make home improvements
Lastly, you can increase the value of your home by improving it manually. This would make the home more valuable than it was when you purchased it, and so, in theory, your home equity would grow even if your mortgage principal balance remained the same. Of course, not all renovations bring the same amount of value to the home, so if your goal is to boost your home equity, some research in what improvements are better than the others could be quite helpful.
Calculating home equity
Calculating home equity is an easy matter, but in order to do it, you first need to do some research and obtain specific information.
The first step is to get your home’s estimated market value at the moment when you wish to do the calculation. If you purchased a home several years ago, the market value of the home back then is likely not the same as the market value of the home now. Getting the current market value can be done via some online home price estimator tools, or you could contact a local real estate agent, or even a lender, who would appraise your home to determine its current value.
Once you get the fresh market value of your home, all you need to do is subtract your mortgage balance, meaning the amount that you have yet to pay. What remains is all yours, and it represents your home equity.
Using home equity for borrowing
So, now that you know how to calculate your home equity and how to improve it, let’s take a look at what you can do with it. The first thing that comes to mind is using it for borrowing, which can be a good way to get some cash for further renovations and also a way to consolidate debt.
As we covered before, building up your home equity enables you to take out home equity loans, as well as home equity lines of credit. The amount that you can borrow is bigger if your down payment is larger, and as close you get to paying off your mortgage, the more of your home actually belongs to you. That makes your home equity grow, and the loans and lines of credit get bigger as a result, as well.
Now, one thing to note is that home equity loans only make sense for those people who seek to take advantage of long repayment terms and low interest rates. They have their benefits, as well as their drawbacks, and you should do well to inform yourself of both before you make that move.
For example, the biggest benefits of using home equity are low interest rates and certain tax benefits. Lower interest rates come from the fact that using your own home for a better line of credit or an equity loan makes it more secure. Lenders and banks know that a lot is at stake for you, and you will not be able to afford to play around. You will have to be serious about it; otherwise, you might lose your home, which, to them, means that you will have to find a way to respect their terms or end up being homeless while still having a mortgage to pay.
As for the mentioned tax benefits, they come from the 2017 Tax Cuts and Jobs Act, which essentially says that homeowners are allowed to deduct the interest on lines of credit and home equity loans if the funds are used for capital improvements. In other words, if you buy, build, or improve your home (which secures the loan) in a substantial way, you get to reduce the interest on the loan/lines of credit.
On the other hand, there are also certain drawbacks on using home equity, of which we have identified three — the cost of borrowing, the risk of losing your house, and the potential to misuse the money.
When it comes to borrowing costs, you should keep in mind that some lenders out there might charge fees for home equity loans or lines of credit. You can check that out in the annual percentage rate, which includes the interest rate, plus other loan fees. Next, we mentioned the risk of losing your house. We already touched upon this issue before, and it emerges because home equity debt is secured by your very own house. If you fail to make payments in time, your lender can legally foreclose on your home. Not only that, but if the housing value happens to go down, you might even get extra debt on top of that.
So, you would lose your home and have to pay more than what it is actually worth, all because of missing payments. So, make sure that you have several payments worth of money put on the side or that you have something to sell or someone to borrow from in case you find yourself in a situation where you cannot afford to make the payment in time on your own.
Lastly, we mentioned the third drawback of misusing money. Essentially, this is the risk that everyone is exposed to, as they might get tempted to use home equity in a way where they expose themselves to risk with no real reward in the end. You should only use home equity to finance moves and expenses that will pay you back in one way or another. Starting a business or renovating your home to increase its value are good examples, and so are paying for college or consolidating high-interest debt.
On the other hand, using home equity to go on a luxurious vacation only to come back to debt and no increase in value or some other way to profit is an example of bad use.
What kinds of home equity loans are there?
There are only two types of home equity loans, so there are not too many options to choose from. You can essentially pick between:
1. Home equity loans
This is sort of like a second mortgage. It is a debt secured by your property. Essentially, you use your home as a kind of collateral, and in exchange, you get a sum of money from the lender. After getting the loan, you start repaying it, with interest. The amount you have to pay is agreed upon with the lender prior to signing the deal, and you have to make payments regularly, each month, on a specific date. You will also agree with the lender on how long you will be making these payments, which will impact the amount that you have to pay per month.
2. Home equity lines of credit
Known as HELOC, home equity lines of credit essentially work similarly to a credit card. You get a specific credit limit, and you can withdraw any amount of money up to that limit during the initial draw period, which is often up to 10 years. As you continue to make payments and pay down the HELOC principal, the credit revolves, allowing you to use it again. This can be very useful to obtain cash quickly if the need arises.
You can also choose interest-only payments or a combination of principal and interest payments, whichever you prefer depending on your personal situation.
One more way to tap into home equity comes in the form of reverse mortgages, which is only available to those who are 62 or older. Reverse mortgages allow homeowners to withdraw a portion of their equity, provided that they own their home in full or have a major amount of equity. Unlike home equity loans r HELOC, this method does not require you to pay the debt monthly. Instead, the lender will pay you money each month, and you simply continue to live in your home. The loan is then repaid after the borrower’s death or in cases where they sell the home or permanently move out.
Finding the best home equity loan
Lastly, before we conclude this guide, let us talk about how you can find the best home equity loan. Obviously, different lenders have different borrowing standards, rates, and alike, so it can be beneficial to shop around a bit and not just accept the first deal you run into. However, there are some things that are shared by most, if not all, lenders.
That includes a high credit score (620 and above), where the best rates come if your credit score is above 700. Then, there is a maximum LTV (loan-to-value) ratio, which is 80%, or 20% equity in your home. They will also require you to provide documentation that proves your ability to make regular payments, and lastly, they will want a debt-to-income ratio of up to 43%. That means that your monthly income needs to be high enough that your monthly payment will be 43% of what you receive per month, at maximum.
Home equity is a great way to get a loan, or lines of credit, or as a financial tool, in general. It can help you pay for big expenses, it can help you renovate your home, pay for college, start a business, and more. The lenders love it because property has permanent value, and it is the most valuable thing that most people possess, which works as a guarantee that they will respect the terms of their loans if they wish to keep their homes. However, since it all brings a huge amount of risk, you should consider your moves and capabilities very carefully, and not rush into it blindly. And, finally, definitely shop around different lenders to find the best deals with the lowest risk and the highest reward before you sign the final deal.
Ali is a freelance writer covering the cryptocurrency markets and the blockchain industry. He has 8 years of experience writing about cryptocurrencies, technology, and trading. His work can be found in various high-profile investment sites including CCN, Capital.com, Bitcoinist, and NewsBTC.
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