Each year, many people tap into the equity in their homes to fund remodeling projects, pay for weddings, consolidate high-interest debt, or for other reasons. If you’re thinking about borrowing against your home equity, the following are some important things to know to help you make an informed decision.
What Is Home Equity?
Home equity refers to the amount of your home that you own based on its current market value. If you buy a $300,000 home with a $60,000 down payment, for example, you will have $60,000 in equity after the closing.
There are three ways that home equity increases. The first is through home appreciation. The value of real estate typically increases by 3.5% to 3.8% annually. As the value of your home increases, the equity you have in your home also goes up.
Home equity also increases as you make your monthly mortgage payments. A portion of your payments goes towards interest, while the rest goes towards repaying the principal. The principal payments slowly increase your home equity over time.
Finally, home equity can also increase with the completion of certain home improvement projects. If you have an unfinished basement, for example, finishing it will increase your livable space and, most likely, increase your home equity.
How Is Home Equity Determined?
Knowing how much equity you have in your home can give you an idea of how much you can borrow. You can estimate how much equity you have in three simple steps.
1. Find Out the Value of Your Home
You’ll first need to find out how much your home is worth. Unless you just recently purchased it, the current value of your home will most likely be different from when you bought it. You can estimate the value of your home by comparing it to similar homes that are for sale in your neighborhood.
2. Find Out the Payoff Amount
You can easily find out how much you still owe on your home by contacting your mortgage lender, who will provide you with a payoff statement.
3. Calculate Your Home Equity
After you’ve determined your current home value and know how much you still owe on your home, you can easily estimate your equity. You simply subtract the payoff amount from the value of your home.
Example: Your home is currently valued at $350,000. The payoff amount of your loan is $215,000. Therefore, your home equity is $135,000 ($350,000 – $215,000).
How Do Home Equity Loans Work?
There are two types of home equity financing to consider. The first is a home equity loan and the second is a home equity line of credit (HELOC). Your home equity is used as collateral in both loans.
A home equity loan allows you to borrow up to a certain amount against the equity you have in your home. The amount you can borrow differs depending on the lender but may be up to 85% of your home equity.
Home equity loans can be used for many different purposes. They have fixed interest rates, which are locked in when the loan is created. If you’re approved, you’ll receive a lump-sum payment for the full amount. You’ll then repay it with fixed monthly payments.
When Should You Consider a Home Equity Loan?
A home equity loan is a good option when you need to borrow a large amount at once. For example, if you hire someone to install new flooring throughout your home, you’ll need to pay that person for the materials and installation.
A home equity loan is also a good option if you need fixed monthly payments so you’ll know exactly how much you’ll owe every month. These loans also usually have lower interest rates than other borrowing options, like credit cards. This allows you to save money on interest.
How Do HELOCs Work?
The second type of home equity financing is known as a home equity line of credit (HELOC). These loans are different from home equity loans in terms of how you receive and repay the money you borrow.
With a HELOC, you’re given a line of credit that you can draw from as needed. This is an important consideration if you don’t know exactly how much you’ll need for a project. It helps you avoid borrowing too much.
To replenish your credit limit, you repay the money you borrowed with interest. The time that your line of credit is active is known as the draw period and may be up to 10 years.
An important feature of HELOCs to consider is that you can make interest-only payments on the money you borrow during the draw period. This can be helpful if you need some extra time to repay it.
When Should You Consider a HELOC?
A HELOC is a great financing option if you need to periodically borrow money and you aren’t sure how much you will need. That’s why these loans are so common with home remodeling projects when the homeowners are doing the work themselves.
If you’re remodeling your kitchen, for example, you could borrow the money you need to put down new flooring. When that’s finished, you could then borrow some more to purchase and install new countertops and cabinets. You can continue the process, repaying the money as you go to replenish your credit limit until the project is finished.
Like home equity loans, HELOCs can also be used for many different purposes. There are usually few or no restrictions on what you can do with the money you borrow.
Which Loan Should You Choose?
Whether you should go with a home equity loan or a HELOC depends on how you’ll use the money you borrow. It also depends on whether you need a large lump sum upfront or you need to periodically borrow money.
Before you make a decision, be sure to carefully consider the pros and cons of each loan type.
Click on the following link to learn more about home equity financing options.