You have surely been told that one of the biggest advantages of a home purchase is that it lets you build equity in the property, and equity can be tapped for different purposes.
Maybe you can use it to have your kitchen renovated. You can also use it to pay for a credit card debt with high interest, or it can help cover your kids’ college tuition.
But what is equity in the first place? For what and how will you be able to use it? Read on to know more about equity, how it works, and what makes it so valuable in the first place.
What Is Equity, and How Does It Work?
Equity is the difference between the current worth of your home and how much you owe on your mortgage.This means that if your house is worth $150,000 and you owe $50,000 on your mortgage loan, your home will have an equity of $100,000.
There are two ways to increase your equity. The amount of equity in your house will increase while you pay your mortgage. Your equity also increases when the value of your property goes up.
On the flipside, your equity may fall if the value of your home drops at a much faster rate than the speed of paying down the principal balance of your mortgage.
It doesn’t matter if you are looking for a good way to consolidate debt or need some cash for an upcoming home renovation since borrowing against your home’s value can be a viable option. As you pay off your property, it will be possible to build equity that can be used later on for home equity lines of credit or loans.
Since equity can be used for loans or you can tap into this when trying to sell your house, this makes equity an excellent financial tool. If your down payment is bigger and you pay more to your mortgage, there is a bigger chance that you will increase your overall equity.
If you have plans to use your equity, the steps you should follow are the following:
- Build your home equity.
- Calculate your home equity.
- Think of the advantages and disadvantages of a home equity loan.
- Check if you are qualified.
What Is Equity in a Home?
Equity in a home is the difference between the value of your home and the current balance of all the liens on the property. These will include how much you still owe on the mortgage together with other debts that were secured through your home.
The initial equity on a home is acquired with your down payment that you made when you purchased the property.
From here, the equity on a home can be increased in a couple of ways. One is every time you pay for the principal portion of the mortgage, and second is if the value of your home sees an increase in the marketplace.
An Example of Home Equity
Here is a good example of home equity and how it changes over time:
Say you purchased a home worth $200,000. You were able to secure a down payment of 10% of the purchase price of your home, which is $20,000. The lender will then give you a mortgage loan worth $180,000.
If the value of the sales price is $200,000, your equity will be $20,000 ($200,000 minus $180,000).
Then fast forward two years. All of your mortgage payments have been made on time, and as of now, you owe $170,000 on the mortgage. Maybe the value of your home also jumped during these couple of years to $210,000.
Your equity will now be at $40,000 ($210,000 minus $170,000).
The value of your home can also work against you.
Say you were able to pay down the mortgage loan to $170,000, but the value of your home has unfortunately lowered to $195,000. Your equity will now be $25,000 ($195,000 minus $170,000).
To determine the equity, it is important that you know your home’s value.
A real estate appraiser is the only person who can provide an official valuation of the worth of your home in the current market. However, you can estimate the value of your home through checking the comparable home sales in your neighborhood or through checking with the online sales of real estate that offer their home value estimates.
Take note, however, that such estimates are not accurate all the time, and they exist only to provide a rough estimate of the current worth of your home.
What Is Negative Equity?
Equity in your home is how much the value of your home is versus the financed amount. Your equity can change as the value of your home fluctuates and as your loan is paid down. If the value of your home drops lower than the outstanding loan balance, this is when you will get a negative equity.
In order to calculate negative or positive equity, you will first determine the value of your home and then calculate the balance of your home. The difference between the loan balance and home value is your negative or positive equity.
You can get an initial estimate of the value of your home online, and then you could look for a real estate agent in your local area to prepare a custom analysis for you. Many local real estate agents will be more than happy to conduct this type of analysis for you free of charge.
After that, you can check your mortgage statement to know your existing loan balance. You can also do your own calculations for loan pay down with the use of the specific rate and amount of your loan.
What Is an Equity Home Loan?
An equity home loan refers to the loan for the fixed monetary amount secured by your property. You will repay this loan with equal payments every month over the fixed term, similar to your original mortgage. When you fail to pay back the loan as agreed upon, there is a possibility that your lender will have your home foreclosed.
Most of the time, the amount you will be able to borrow is limited to 85% of your home’s equity. The actual loan amount will depend on your credit history, your income, and your home’s market value.
You can ask your family and friends for suggestions for lenders before you shop and compare terms. You can also talk with banks, mortgage companies, mortgage brokers, and credit unions. However, take note that brokers won’t lend you money. They will only assist in arranging your loan.
Interview lenders and ask them to explain the available loan plans to you. If there is something you don’t understand about the conditions and terms of the loan, always ask questions. They might mean higher costs. It is never enough that you just know how much the interest rate or monthly payment is.
The annual percentage rate (APR) for an equity home loan considers financing charges and points. You have to be extra attentive to fees that include the loan processing or application fees, underwriting or origination fees, funding or lender fees, document recording or preparation fees, broker fees, and appraisal fees. These could be quoted as interest rate add-ons, origination fees, or points. If points as well as other fees get added to the amount of your loan, you will be paying more to finance them.
You should inquire about your credit score. Creditors use credit scoring to help them decide if they will offer you credit. Details about you and your credit experiences will all be collected from your credit report and credit application.
Negotiate with several lenders and read closing papers with care before signing anything.
What Is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is the revolving credit line that is similar to a credit card. It lets you borrow as much you want or need and any time that you need it. This can be done through writing a check or with the use of the credit card that is connected to the account. Exceeding your credit limit is not allowed.
Since a HELOC is a line of credit, it will require you to make payments on the amount you borrowed, not the full available amount. HELOCs may also provide specific tax benefits that you cannot expect from other types of loans. It is advisable to consult a tax adviser or accountant for details.
Similar to home equity loans, a home equity line of credit requires you to use your house as the collateral for your loan. It may put your property at risk if you make late payments or if you fail to pay at all.
Loans that have a large balloon payment—the lump sum that is often due when the loan ends—may cause you to borrow more cash to have the debt paid off, or these might end up compromising your home if you are not qualified for refinancing. Also, if you decide to sell your house, many plans may also require you to simultaneously pay off the credit line.
How Can You Invest with the Equity in Your House?
When you are an investor, it is important that you always search for ways to ensure that your money will work to your advantage. Unfortunately, saying it is easier than doing it.
There are lots of different choices and daunting sets of criteria you need to meet. Just the thought of learning a new approach to investment might even sound like too much, particularly when you are dealing with the real estate industry. The good news is that there is a particular approach familiar to most investors, and this is none other than equity.
Equity is usually overlooked for the reason that this is an unassuming vehicle for investment. Many people are already regaining equity in investment properties, yet they are unaware of how they can harness its full potential.
Some homeowners who were able to establish a small amount of equity might be tempted to allot a portion of their wealth to their immediate needs or wants. But the main question now is, how can you invest using the equity in your home?
Making the most out of the equity built up in your house is one of the smartest ways for financing other investments like a rental property, vacation home, or improving your retirement portfolio. This can be easily done through taking out a home equity line of credit. A financial advisor can help you determine how you can accommodate your specific needs best.
As mentioned earlier, a HELOC is a revolving and variable-rate credit line similar to a credit card with a maximum limit for spending. A homeowner can borrow cash, pay this back, and borrow more as required. It is also easy to access the funds.
Since interest is only charged on the actual money borrowed, HELOCs work best for people who have ongoing needs such as long-term improvement projects or recurring expenses. This might also come in handy during emergency cases like an unexpected unemployment.
The levels of borrowing are dependent on the worth or value of your home. If the housing market is strong, you can often tap as much as 65% of your home’s appraised value minus the remaining balance on your first mortgage.
The Bottom Line
No matter how you plan to use the equity in your home, whether it is to increase your home’s value or improve your current financial position, always make sure that you work only with a reliable lender who will go through the figures with you to make sure that you continue to pay your traditional mortgage together with the new home equity loan. Make sure you also have a solid plan to improve your finances using your home equity money.
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