Your home equity is the difference between what you owe on your mortgage(s) and what your home is currently worth if you sold it today (the appraised value). For instance, if the remaining balance on your mortgage is $195,000 and the market value is $295,000, you have $100,000 of equity in your home. Your equity increases in two ways. First, as you make monthly payments, you gain equity by the amount that the mortgage principal is reduced each month. Second, your equity increases as the market value that you can sell it for increases. The two combined determine the total equity you have in your home.
It’s not common and it hasn’t happened to large numbers of homeowners since the Great Recession, but your mortgage can become higher than the value of your home. When you owe more on the mortgage than the house can be sold for, it is known as an underwater mortgage. It means you have zero equity in your house. This can also happen in two ways. First, the market value of the house can drop below the balance remaining on the mortgage. Second, you could theoretically take out additional mortgage loans that when combined with the original mortgage add up to more than the market value of the loan.
You’ve probably heard that owning a home is a path to building wealth. The reason is that equity is an important financial tool that gives you financial options that you otherwise would not have. One of the most common ways to use equity is by selling your current home to move up to a larger and more expensive home.
But there are other ways you can make equity work for you. You can also borrow against your equity to pay for major home improvements or to consolidate other debts. Another way is to plan for your retirement, which can be done in many ways. You could pay off the existing mortgage to own the home free and clear so that you don’t have mortgage or rent payments during retirement. The equity in your home can also be used to take out a reverse mortgage for income during retirement. Another is borrowing against your equity to invest the money in something that pays a higher rate of return to increase the size of your retirement nest egg.
Your equity is like having money in the bank but in most cases, the only way that you can access it is by borrowing against it.
Borrowing against your equity can be a smart way to borrow money because these loans come with the lowest interest rates and some tax breaks. Much lower than the interest charged on personal loans and credit cards. That lower interest rate can save you a lot of money, especially for large ticket items that take years to pay off. However, borrowing money always involves risk so do it wisely. Personal loans and credit card loans are unsecured debts. These loans could lead to repossessing a car or bankruptcy, but your home should not be at risk. The risk with any type of home equity loan is that if you fail to make your payments, your lender could take your home through the foreclosure process.
Here are the 3 most common ways to tap into your equity along with tips to help you determine which one might be best for your circumstances.
Home Equity Loan. This is also known as a 2nd mortgage. This can work well for people that want to keep their original loan exactly the way it is. A home equity loan should be separate from the first loan. You continue making payments on the first loan and begin making separate payments on the new loan. One reason for doing this is that the second loan is a junior loan. If you default on the second loan, it’s more difficult for the lender to foreclose because they must pay off the first loan. Home equity loans are better for people with a high credit score (above 700) because they will receive the best interest rate and can more easily qualify for the second loan. You receive all the borrowed money at one time and make a stable monthly payment. It also tends to be better for borrowers with lower debt compared to their income.
Cash-out Refinance. This is a new loan that replaces the original loan. The new loan is for a higher amount. You receive cash for the difference between the balance owed on the first loan and the higher amount owed on the new loan. If your first loan was for 30 years and the new loan is also for 30 years, the clock for repaying the loan starts over. But you could pay it off sooner if the new loan is for 25, 20, or 15 years. This new loan becomes the first mortgage on your home and can be more sensitive to foreclosure if you default. Generally, you can expect your monthly payment to increase but you only make one monthly payment. Cash-out refinancing tends to be easier to obtain for lower credit score borrowers (620+) and borrowers with higher debt compared to their income.
Home Equity Line of Credit. This is also known as a HELOC. As a line of credit, you borrow the money only when you need it. Your monthly payment will increase as you borrow more money (much like a credit card). Lenders offer home equity lines of credit in a variety of ways, making it important that you understand all the conditions of the loan (including the foreclosure possibility). No one loan plan is right for every homeowner. Contact different lenders, compare options, and select the home equity credit line best tailored to your needs. HELOC loans tend to be better when you have unpredictable funding needs. Also, for borrowers with higher credit scores (700+) and lower debt compared to their income.
Before deciding on any of these home equity choices, speak with a mortgage professional to help fully understand the pros and cons of each as they apply to you.
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