Home equity is simply the amount of your current home that you have already paid off. For example, if your home is worth $300,000 and your mortgage still has a balance of $150,000, then you have $150,000 of equity in your home. Your home equity will increase when the value of your home increases; you don't acquire it solely by paying off your mortgage. If your initial mortgage balance was $250,000, then you gained $50,000 of equity from market appreciation. Home equity is always listed as an asset on the balance sheet, and it is often one of the most significant assets in many U.S. households. It may also constitute the key value of any real estate that you own.
History of Home Equity
The Tax Reform Act of 1986 paved the way for the use of home equity as a source of funds for taxpayers. This act rescinded the deductibility of interest on credit cards but preserved the mortgage interest deduction. This distinction led the banking and credit union industry to start aggressively marketing various forms of home equity loans to the public.
At first, these loans were advertised as debt consolidation vehicles, where consumers could convert nondeductible credit card and car loan interest into deductible home loan interest. But this quickly morphed into a message that these loans were a means to “Live Richly” and to “Seize the Moment”.
The public bought into this history ofmessage with a vengeance. Home equity loans mushroomed from a mere $1 billion in the 1980s to over $1 trillion just a few years later.
The public bought into this message with a vengeance. Home equity loans mushroomed from a mere $1 billion in the 1980s to over $1 trillion just a few years later.
Lenders were willing to make loans to homeowners for 100% of the equity in their homes, including their first mortgages. A declining interest rate environment coupled with the rise in home values during this period further encouraged consumers to “Live Richly” and pay for it using home equity.
Then the Subprime Mortgage Meltdown hit in 2008, and many home equity borrowers suddenly found themselves upside down with their homes. They now owed more on their residences than they were worth in the open market, and the ensuing recession made it impossible for many of them to continue making their mortgage payments.
Since then, the home equity market has slowly recovered. These loans are now governed with tighter restrictions and still stand as a viable alternative to credit cards or personal loans.
How Can I Access My Home Equity?
There are two main ways that you have to access the equity in your home. One is through a home equity loan and the other is with a home equity line of credit. These loans will allow you to directly tap into your home's equity and either get cash up front or through a line of credit. Home equity is more accessible than ever today, and this trend is likely to continue for the foreseeable future. In most cases, you will have to have a credit score of at least 620 in order to qualify for a home equity loan, and your score will usually have to be even higher to qualify for a home equity line of credit. Your loan-to-value ration must also be at least 80 to 85 percent of the value of the home that you're taking out the loan against.
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Before Trump’s tax laws took effect, borrowers could deduct the interest paid on a first mortgage of up to $1 million. Home equity loan and home equity line of credit interest was also deductible as an itemized deduction, regardless of what the loan proceeds were used for. But Trump’s new tax laws have changed all of that. Now only the interest paid on first mortgages of $750,000 or less is tax deductible. The loan balance for home equity loans and lines of credit is capped at $100,000, but more importantly, interest on any type of second mortgage is now only deductible if the loan proceeds are used to build, buy or substantially improve the residence that the is taken out against. This is a major new limitation for taxpayers, as this means that home equity loans and lines of credit that are used for such purposes as debt consolidation, medical or educational bills now charge nondeductible interest. These limitations will most likely make a noticeable dent in the number of taxpayers who are able to itemize deductions from now on.
Home Equity Loans vs. Home Equity Lines of Credit
Although both types of loans allow you to access your home equity, they are fundamentally different in nature. A home equity loan is essentially a second mortgage, where you will receive a lump sum of cash up front and begin paying interest on the entire loan amount immediately. The payments and the interest rate are fixed when the loan is issued, and the repayment schedule can stretch out for as long as 30 years in some cases.
Variable Interest Rates Most home equity lines of credit charge a variable rate of interest that contains a spread. The rate of interest is based on a major financial benchmark index such as the U.S. Prime Rate Index that is published daily in The Wall Street Journal. The lender will then add an additional amount to this rate (a spread) in order to make a profit. Some home equity lines of credit offer “interest only” payments where the borrower only has to pay the interest each month and none of the principal of what he or she has withdrawn.
Fixed Interest Rates Unlike home equity lines of credit, home equity loans only charge a fixed interest rate that remains constant throughout the life of the loan. The rate is set by the prevailing interest rate environment but remains unchanged when interest rates rise or fall. Some home equity lines of credit also allow borrowers to lock in a fixed interest rate for an additional fee.
Pros and Cons of Home Equity Lines of Credit
Home equity lines of credit are more flexible by nature than their home equity loan cousins, and the borrower only has to pay interest on the outstanding balance that is actually withdrawn from the line of credit. The interest only option also allows borrowers who are on a tight budget to make lower payments, at least for a while. But some of these lines of credit also expect a balloon payment to be made at the end of the draw period or the repayment period. And the variable interest rates that these lines of credit charge can increase when interest rates rise, thus raising the amount of the monthly payment. The maximum amount of interest that a home equity line of credit is allowed to charge can be as high as 18% in many states. But the initial interest rate that a home equity line of credit charges is usually a percent or two below what a home equity loan will charge.
Pros and Cons of Home Equity Loans
There is no uncertainty with a home equity loan. The interest rate, the repayment schedule and the amount of money received are all clearly defined. However, if interest rates fall after the loan has been issued, then the borrower may be stuck making interest payments that are one or two percentage points above current market rates. Furthermore, the borrower will have to pay interest on the entire loan balance right from the outset, as opposed to the line of credit holder who only has to pay interest on the amount that has been withdrawn. Home equity loans also generally don't require a down payment. However, if a borrower takes out a home equity loan and then interest rates rise, then the borrower can comfortably continue making payments at the rate that was locked in when the loan was issued instead of at higher current rates. But tapping out your home's equity in a single loan will work against you if the property values in your area start to drop. Of course, both types of loans require standard underwriting procedures and come with the usual litany of closing costs, including origination fees, appraisal fees, documentation and legal fees and brokers' fees. Lenders will examine your credit score, credit history, net worth, the loan-to-value ratio as well as your home's market value in order to determine how much money you can get. But buyers need to be sure to read the fine print on the terms of their loans before signing on the dotted line. Appraisal fees can easily run between $150 and $300, while origination and brokers' fees can be at least one point in many cases. But this may still be preferable to doing a cash-out refinance in some cases.
When Should I Use a Home Equity Loan vs. a Home Equity Line of Credit?
In many cases, borrowers are at liberty to use either type of loan when they need cash. But knowing which type of second mortgage to use is not always easy. In some situations, there are clear-cut reasons to use one type of loan over the other, but many times this is a gray area where the advantages and disadvantages of each type of loan must be carefully considered before signing on the dotted line.
When a Home Equity Loan May Be Better
If you need a single, predetermined amount of money up front and don’t expect to need more in the future, then a home equity loan is probably going to be the better choice. The rate of interest that this loan charges will be higher than a home equity line of credit will charge, but it will be a fixed rate of interest that will not fluctuate with prevailing interest rates. This type of loan is also appropriate when interest rates are rising, as the borrower may eventually end up paying less interest on the loan than they would with a line of credit. For example, if the Prime Rate is 3% when you take your home equity loan, then you might pay an annual percentage rate of 8% over the life of the loan. But if interest rates then rise to 11 or 12%, then you may come out ahead of someone who used a line of credit instead.
When a Home Equity Line of Credit May Be Better
A home equity line of credit may be the better choice for you if you are going to need to draw out funds from your second mortgage on a periodic basis. For example, if you will need to make periodic withdrawals to pay for college tuition or make home improvements, then a line of credit definitely makes more sense than a home equity loan. A home equity line of credit may also be the better choice if you know that your income is going to increase sometime in the near future. If your budget is tight right now and interest rates are low, then you might consider taking out a HELOC that charges interest-only payments for a set period of time before starting to require the repayment of principal. If you know that you are going to be promoted at your job, then you should be able to cover the new higher payments with the raise that you receive. Of course, some situations are more complex than the ones outlined here, and in those cases it would be wise to seek professional help from a mortgage broker or financial planner in order to make the choice that’s best for you.