Equity is simply a positive monetary value. Put more simply, it’s the money you have left over when all your debts are paid. For most people the largest source of equity is their home. If your house is worth $200,000 and you owe $150,000 on the load, then you have $50,000 worth of equity in the home.
For years, people were encouraged to leverage the equity in their homes to finance renovations or to reduce credit card debt. Unfortunately, many of the people who leveraged their equity found themselves with negative equity when the housing bubble collapsed, leaving them with debts that outweighed the value of their homes. While an equity loan can be a useful tool, when not used judiciously, it can lead to financial disaster.
Home Improvement Loan
It makes the most sense to leverage home equity for renovations that will improve the value of your home by more than the amount of equity against which you borrow. If homeowner Bill takes out an equity loan for $20,000 to update his kitchen and ads $35,000 to the value, the equity loan is smart. But if the home value falls, the loan does him little good.
Consolidate Credit Card Debt
If you use home equity to consolidate credit card debt, be sure to stop using the cards until the debt is paid. Otherwise, you are actually increasing your debt with open lines of credit plus a home equity loan.
Home Equity Line of Credit Guide
To use the equity in your home, you must first have it appraised. The appraisal value, less the amount owed on the first mortgage represents the equity value against which you can borrow. It is strongly recommended that your combined first mortgage and equity loan debt does not exceed 75% of the home’s value. This will help to minimize the negative effects of market fluctuations in the home’s value and interest rates.
So if Bill’s home was appraised at $200,000, leaving $50,000 worth of equity, he should be careful not to borrow more than $25,000. This would put his total debt at $175,000, or 75% of the property’s value.
If Bill is a do-it-yourselfer, he should be careful to get an equity line with flexible withdrawal terms. For instance, some lenders require a minimum $300 draw for each withdrawal, with checks. If bill were paying a contractor, this would be a fine scenario. But doing the job himself may require several trips back and forth to the home improvement store. For this reason, Bill should look for a plan with a credit card attached to it that lets him draw as little as necessary to pay for what he needs.
Bill will not automatically qualify for a home equity loan simply because he holds an equity stake. His credit score will play a strong role in both loan approval and the interest rate charged.
Bill must also be prepared to pay back the loan within the specified time period. He is likely to have ten years to draw on the equity line and then another ten years to pay it off. Be sure not to sign on for a “balloon payment” equity loan that requires payment in full at the end of the draw period.
Do what you can to get a fixed rate on your home equity loan. Some loans offer a variable rate during the draw period that you can lock in for the life of the loan. Others may transition to a fixed rate once the draw period ends.
Bill should also expect to pay for the home appraisal up front, along with loan closing costs. Some banks require the borrower to establish the loan costs as the first draw on the equity line.