The equity in your home is the difference between what you owe on your mortgage (s) and the current value of your home if you sell it today (appraised value). For example, if your mortgage balance 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 earn equity in the amount by which the mortgage principal is reduced each month. Second, your equity increases as the market value for which you can sell it increases. The two combined determine the total equity in your home.
This is not common and has not happened to a large number of homeowners since the Great Recession, but your mortgage can get higher than the value of your home. When you owe more on the mortgage than the house can be sold, it’s called an underwater mortgage. This means that you have no equity in your home. This can also happen in two ways. First, the home’s market value may drop below the remaining mortgage balance. Second, you could theoretically take out additional mortgages which, combined with the original mortgage, are more than the market value of the loan.
You’ve probably heard that owning a home is a way to build wealth. The reason is that equity is an important financial tool that gives you financial options that you wouldn’t have otherwise. One of the most common ways to use equity is to sell your current home to move to a larger, more expensive home.
But there are other ways to make equity work for you. You can also borrow against your equity to pay for major renovations or to consolidate other debt. Another way is to plan for your retirement, which can be done in a number of ways. You could pay off the existing mortgage to own the home for free and so you don’t have to pay a mortgage or rent in retirement. Equity in your home can also be used to take out a reverse mortgage for income during retirement. Another is to borrow against your equity to invest the money in something that pays a higher rate of return in order 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 to access it is to borrow against it.
Borrowing against your own 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. This lower interest rate can save you a lot of money, especially for larger items that take years to pay off. However, borrowing money always comes with risk, so do it wisely. Personal loans and credit card loans are unsecured debt. These loans could lead to car repossession or bankruptcy, but your home should not be in jeopardy. The risk with any type of home equity loan is that if you don’t make your payments, your lender could take your home through the foreclosure process.
Here are the 3 most common ways to tap into your capital, along with tips to help you determine which one is best for you.
Home equity loan. This is also known as a 2sd mortgage. This can work very well for people who want to keep their original loan exactly as it is. A home equity loan should be separate from the first loan. You continue to make payments on the first loan and start making separate payments on the new loan. One of the reasons is that the second loan is a junior loan. If you default on the second loan, it is more difficult for the lender to foreclose because they have to repay the first loan. Home equity loans are best suited for people with a high credit score (above 700) as they will receive the best interest rate and can more easily qualify for the second loan. You get all the borrowed money at once and make a stable monthly payment. It also tends to be better for borrowers with less debt than their income.
Refinancing of collection. This is a new loan that replaces the original loan. The new loan is for a larger amount. You receive in cash the difference between the balance owed on the first loan and the greater amount owed on the new loan. If your first loan was for 30 years and the new loan is also for 30 years, the loan repayment period starts again. 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 may be more susceptible to foreclosure in the event of a default. Typically, you can expect your monthly payment to increase, but you only make one monthly payment. Cash refinancing tends to be easier to obtain for borrowers with low credit scores (620+) and borrowers with higher debt relative to their income.
Home equity line of credit. This is also known as a HELOC. As a line of credit, you only borrow money 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, so it’s important that you understand all of the loan terms (including the possibility of foreclosure). No loan plan is right for all homeowners. Contact different lenders, compare options, and select the home equity line of credit that best suits your needs. HELOC loans tend to be best when you have unpredictable financing needs. Also, for borrowers with a higher credit score (700+) and lower debt relative to their income.
Before deciding on any of these home equity choices, talk to a mortgage advisor to help you fully understand the pros and cons of each for you.
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Author Biography: Brian Kline has been investing in real estate for over 35 years and has been writing about real estate investing for 12 years. He also draws on more than 30 years of business experience, including 12 years as a director at Boeing Aircraft Company. Brian currently lives in Lake Cushman, Washington. A vacation destination, close to a national and the Pacific Ocean.