Home equity is one of the most important sources of wealth for many Americans. If managed carefully, it can help you finance home improvements, pay for education or take a once-in-a-lifetime vacation.
Here’s what you need to know so you can make the best use of it.
What is home equity?
Your home equity is the amount you would clear if you were to sell the property for its appraised value. Estimate your home’s potential sale price by searching real estate valuation websites, looking at recent sales of similar properties or talking to a local real estate agent, then subtract the balance of your mortgage. Your home equity generally increases as you pay down the mortgage principal and can change with local real estate values.
Best uses of home equity
You should be gradually increasing your home equity, with the ultimate goal of paying off any mortgages and owning the property outright. Not having a loan to pay each month will mean you can get by on less income, which can be handy especially during retirement.
But careful use of home equity during your working years can be a wise move. Because the interest you pay on both a primary and secondary mortgage is usually tax deductible, the cost of carrying the debt can be lower than other types of loans. But there are expenses to take into account. Typically, borrowing against your property incurs costs similar to those you paid when getting the first mortgage, such as appraisal, title check and loan-origination fees, among others, so consider these before taking the plunge.
How to borrow using your equity
To unlock your home equity, you can either refinance the current mortgage or borrow against it. Lenders such as Two Rivers Bank & Trust offer two main ways to do the latter — home equity loans and home equity lines of credit, or HELOCs.
Home equity loans typically provide a specific amount of money up front, and their rates are generally fixed for the life of the loan. HELOCs, on the other hand, usually have variable rates that can move up or down based on a market index. That means your monthly payment can vary, too. But because they are lines of credit, you have the option to make an interest only payment on the amount you’ve borrowed. If you’re financing a big renovation and don’t know what the final price will be, a HELOC might be a better choice, because you can borrow the money as you go.
A word of caution
When you take on a second mortgage in the form of an equity loan or HELOC, the lender can start foreclosure proceedings if you fail to repay the loan, or default. Home equity can be a powerful tool to pay for big-ticket items, but it shouldn’t be used lightly.
Ideally, you’d prepare for major expenses and save money in advance. The costs of sending children to college, taking your mother on her dream Caribbean cruise or adding a second bathroom to the house are usually not the result of spur-of-the-moment decisions. Paying for such things out of pocket is usually a better idea than borrowing, but if you do need financing, using home equity may be the best solution.
When it comes to financial planning, home equity can be your ace in the hole. Use it wisely to finance big life-changing purchases, but don’t squander it needlessly on insignificant things.
Virginia C. McGuire, NerdWallet