What is Home Equity?
Home equity is the difference between the balance owed on liens (such as a mortgage) and your home’s current market value.
Why is Home Equity important?
As you reduce mortgage debt, your home gains value over time and becomes an asset. Other major purchases don’t typically appreciate the way a home does over time. Cars, for example, lose value over time.
Homes are a long-term investment for most people and can be a powerful resource when you need to access the equity they build over time. In general, home equity loan products have competitive interest rates, which are usually much lower than personal loans, credit cards, and cash-out refinances.
What is the difference between a HELOC and a HELOAN?
A home equity line of credit (HELOC) works similarly to a credit card and lets you withdraw on a credit line during a “draw” period, typically 10 years. The credit line limit is determined using the amount of available equity in your home. As you pay down the HELOC, the credit revolves and you can use it again. After the draw period, you enter into a repayment period, in which any remaining interest and the principal balance is due. Repayment periods tend to be longer than the draw period, 15-20 years. Most HELOCs come with variable rates, meaning your monthly payments aren’t fixed.
A home equity loan is a second mortgage that uses your home value as collateral to pull out cash in a lump sum. Once the loan is received, you start repaying it immediately at a fixed interest rate. Interest rates for HELOANs tend to be higher than HELOCs.
What are the best ways to use Home Equity?
It’s typically a good idea to use home equity for major life expenses that enhance your overall financial situation. Popular uses include:
- Large home improvement projects – the interest rate on a HELOAN used for renovations are eligible for tax deductions!
- Consolidating higher-interest debt, like credit cards
- Purchasing a vacation home or investment property
- College tuition
- Starting a business
- Emergency expenses
Which is better, a HELOC or a HELOAN?
This depends on your situation. HELOCs make sense for smaller expenses that will be spread out over time, such as ongoing home renovation projects or college tuition payments. HELOANs make more sense for large upfront expenses, such as a singular home renovation, like redoing your kitchen or consolidating debt. What’s most important is that you pay attention to repayments and make sure to keep up. The risk with both HELOCs and HELOANs is that if you default on payments, your home is what you put up for collateral.
How do I find out how much Equity is in my Home?
A home equity calculator can give you an idea of what your home is worth and how much equity you may have if you’re thinking about selling your home or borrowing a chunk of your equity.
An appraisal will really nail down the value of your house.
How do I qualify for a HELOC or HELOAN?
Generally, lenders require that homeowners have at least 20% equity in their homes before they can withdraw money through a home equity loan product. This means you need a loan-to-value ratio, or LTV, of 80 percent. A professional property appraisal is done to verify your home’s current market value. Your outstanding mortgage balance is then divided by the appraised value to get a percentage for your LTV ratio.
Lenders also typically look at two things when deciding your interest rate: credit score and existing debt. They generally look for a debt-to-income ratio in the lower 40s or less and a credit score of 620 or higher.
Home values and the term of your loan play a role in how quickly you gain (or lose) equity. When home values rise you can build equity much faster. If the market takes a dive, however, as it did during the Great Recession, you could lose equity and become “underwater” in your mortgage – owing more than your home is worth.
Is the interest paid on a HELOC or HELOAN tax deductible?
Yes, so long as the HELOC is used for home-related investments (home improvements). Interest is capped at $750,000 on home loans (combined mortgage and HELOC/HELOAN). So if you had a $600,000 mortgage and $300,000 HELOC for home improvements on a house worth $1,200,000, you can only deduct the interest on the first $750,000 of the $900,000 you borrowed.
If you are using a HELOC for any other purpose other than home improvement (such as starting a business or consolidating high-interest debt), you cannot deduct interest under the new federal tax law (as of 06/13/2018).
How does a HELOC affect my credit score?
Although a HELOC acts a lot like a credit card, giving you ongoing access to your home’s equity, there’s one big difference when it comes to your credit score: Some bureaus treat HELOCs of a certain size like installment loans rather than revolving lines of credit.
This means borrowing 100% of your HELOC limit may not have the same negative effect as maxing out your credit card. Like any line of credit, a new HELOC on your report will likely reduce your credit score temporarily.