September 8, 2022 • 7min read
Home Equity 101
Are you interested in remodeling your outdated kitchen? Perhaps you're drowning in a sea of high-interest credit card debt, or need money to send your child to college. Or maybe you just want the comfort of a emergency savings account, so that you'll be prepared for any unexpected bills. If you're a homeowner, a home equity loan or line of credit may be right for you. Before you sign on the dotted line, however, make sure you understand the basics of home equity and what's right for your needs.
Home equity financing uses the equity in your home to secure a loan. For this reason, lenders typically offer better interest rates for this type of financing than they do for other, unsecured types of personal loans. Typically, you'll be able to borrow an amount equal to 80 percent of the value of your equity.
Home equity financing is different than mortgage refinancing, which is the process of taking out a new home mortgage loan and using some or all of the proceeds to pay off an existing mortgage (or mortgages) on the property. Keep in mind that because home equity financing is secured by your home, you risk losing your home if you default on the contract. Home equity financing may be either a loan or a line of credit.
A home equity loan (often referred to as a second mortgage) is a loan for a fixed amount of money that must be repaid over a fixed term. Generally, a home equity loan:
When you receive a home equity line of credit (HELOC), you're approved for revolving credit up to a certain limit. Within the parameters of the loan agreement, you borrow (and pay for) only what you need, only when you need it. Generally, a HELOC:
Allows you to write a check or use a credit card against the available balance during a fixed time period known as the borrowing period.
Carries a variable interest rate based on a publicly available economic index plus the lender's margin.
Requires monthly payments that may vary in amount, based on changes in your outstanding balance and/or the prevailing interest rate.
There are many types of HELOCs. Some questions to ask if you're considering one include:
Some HELOCs may cap the monthly payment amount that you are required to make, but not the interest adjustment. With these plans, it's important to note that payment caps can result in negative amortization during periods of rising interest rates. If your monthly payment would be less than the interest accrued that month, the unpaid interest would be added to your principal, and your outstanding balance would actually increase, even though you continued to make your required monthly payments.
The costs associated with getting a home equity loan or line of credit are often similar to those of getting a mortgage. They include:
Before you decide on any one plan, shop around. Interest rates and other costs may vary among lenders. When comparing costs, don't simply compare the annual percentage rate (APR) of one plan against another–particularly if one is a home equity loan and the other is a HELOC. The APR for a home equity loan (second mortgage) takes any points and financing charges into consideration; the APR for a HELOC does not. Compare total costs.
If your principal residence will secure the home equity financing plan, the Truth in Lending Act gives you three days from the date the account is opened to cancel the contract. If you cancel the contract, do so in writing. The lender then cancels any security interest in your home and returns all fees you paid.
There are some other points to consider before you decide to seek a home equity loan or line of credit. When you sell your home, you'll have to pay off the equity loan or line of credit.
If you sell shortly after borrowing the money, the cost of obtaining the financing may undercut your profit in the sale. Additionally, the cost of obtaining an equity line of credit might be prohibitive if you only draw a small amount from it. Finally, leasing your home could be prohibited by the terms of a home equity financing contract.
What's best for you will depend on your individual circumstances, but here's a general guideline.
If you'll need a fixed amount of money all at once for a certain purpose (e.g., remodeling the kitchen or paying off other high-interest debts), you might want to take out a home equity loan.
If you'll need an indeterminate amount over a few years (e.g., funds for college or a cash reserve account), you might want to obtain a HELOC.
You can use Patelco's home equity loan and line of credit calculator to see how much you can borrow from your home.
You may be able to deduct the interest you pay on up to a certain amount (consult your tax advisor or the IRS for the exact amount) of the principal you borrow under certain home equity financing plans. The interest you pay is generally deductible regardless of how you use the loan or line of credit proceeds (unless you use the proceeds to purchase tax-exempt vehicles). In other words, the loan or line of credit doesn’t have to be obtained to buy, build, or improve your residence.
Source(s) consulted: Broadridge Financial Solutions.
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