Wednesday, December 1, 2021
Homeowners looking for a way to access a large sum of money may not have to look too far if they have accumulated equity in their home. Using the equity from your home can provide the cash you need for renovations or improve your overall financial position. And, this money can often be borrowed at a relatively low interest rate.
What is home equity?
Home equity is the portion of your home that you’ve paid off. It’s the difference between what the home is worth and how much is still owed on your home loan. As your home’s value increases over the long term and you pay down the principal on the mortgage, your equity grows. Home equity is typically used for big expenses and often represents a more cost-effective financing option than credit cards or personal loans with high interest rates.
How home equity works
Tapping your home equity can be a convenient, low-cost way to borrow large sums at favorable interest rates in order to pay for home repairs or debt consolidation. However, the right type of loan depends on your specific needs and what you’re planning on using the money for.
- A home equity line of credit (HELOC) is a variable-rate home equity loan that works like a credit card. With a HELOC, you’re given a revolving line of credit that’s available for a predetermined time frame. HELOCs allow you to spend as you go and only pay for what you’ve borrowed.
- With a home equity loan, you borrow a lump sum of cash up front that you must begin repaying immediately. Home equity loans have fixed interest rates, meaning your payments will be the same every month.
- Cash-out refinancing creates a new, larger mortgage on your home. You’ll use this mortgage to pay off your old one and take out the difference in cash.
Best ways to use a home equity loan
There are not many limits on how you can use your home’s equity, but there are a few smart ways to make the most of your loan or line of credit.
Home improvement is one of the most common reasons homeowners take out home equity loans or HELOCs. Besides making a home more comfortable for you, upgrades could raise the home’s value and draw more interest from prospective buyers when you sell it later on. Other home improvements that yield a solid return on investment include garage and entry door replacements, a new deck, a new roof or an outdoor area addition, like a patio.
A home equity loan or HELOC may be a good way to fund a college education. While student loans are still the most common way to pay for an education, the use of home equity can still be advantageous when mortgage rates are considerably lower than student loan interest rates. Before tapping your home equity, however, look at all the options for student loans, including the terms and interest rates. Defaulting on a student loan will hurt your credit, but if you default on a home equity loan, you could lose your house.
Also, if you want to fund your child’s education with a home equity loan product, be sure to calculate the monthly payments during the amortization period and determine whether you can pay off this debt before retirement. If it doesn’t seem feasible, you may want to have your child take out a student loan themself, as they will have many more income-making years to repay the debt.
A HELOC or home equity loan can be used to consolidate high-interest debt at a lower interest rate. Homeowners sometimes use home equity to pay off other personal debts, such as a car loan or a credit card as they are often able to consolidate debt at a much lower rate, over a longer term and reduce their monthly expenses.
The downside, however, is that you’re turning an unsecured debt, such as a credit card that is not backed by any collateral, into a secured debt – or debt that is now backed by your home. You also risk running up the credit cards again after using home equity money to pay them off, substantially increasing the amount of debt you have.
If you have a significant amount of unsecured debt with high interest rates and you’re having trouble making the payments, it may make sense to consolidate that debt at a substantially lower interest rate, saving yourself money each month. If you have a solid debt payoff plan, using home equity to refinance high-interest debt can help you get out of debt faster.