If the market value of your home is more than what you owe on it, you have what’s called equity in your home—or a ready-to-use cash source. Drawing on the equity in your home makes for an easy and convenient way to improve your life. This borrowing solution is hitting a record high as homeowners are increasingly tapping that cash for all sorts of reasons, in particular making their homes even more valuable.
Not only do you increase the quality of your living, but you increase the value of your home as well. Improvements that typically add to your home’s value include new paint, new flooring, upgrades to the kitchen and bathrooms, and enhancements to the home’s curb appeal.
Other uses for equity
Homeowners are also using home equity cash for other big expenses, like funding a college education. It’s a smart move if the interest rate is lower than that of a student loan. Plus, college is an investment that can potentially put you in a higher income bracket. Another use for home equity is to pay off credit cards, car loans or other higher interest debt, though financial advisors caution against running up credit card debt again and advise borrowers to know all the closing costs involved so that it makes financial sense. Other common uses for equity include using it to invest in the stock market or real estate, pay for a wedding, take a dream vacation, launch a small business, or purchase a boat or RV. Even borrowers with other assets find the equity route more appealing because they may not want to sell taxable holdings that will generate capital gains or pay withdrawal penalties on early IRA or retirement plan distributions.
Know your options
Here are 3 options for a secondary home loan:
1. Home Equity Loan (second mortgage). A home equity loan is a term loan in which the borrower gets a one-time lump sum. The loan is repaid over a fixed term, at a fixed interest rate, with equal monthly payments.
2. Home Equity Line of Credit (HELOC). A HELOC works more like a credit card. You are given a line of credit that is available for a set timeframe, usually up to 10 years. This is called the draw period, and during this time you can withdraw money as you need and only make payments on the amount drawn.
3. Cash-Out Refinance. In this instance you simply refinance your home for a larger amount and take the difference in cash. The closing costs for this type of loan can be rather high in some cases.
How to calculate your home equity
You can figure out how much equity you have in your home by subtracting the amount of money you owe on your mortgage from your property’s value. Depending on your financial track record, lenders may let you borrow up to 85% of your home equity.
The amount you owe on outstanding home loans divided by the market value of your home is considered the combined loan-to-value ratio. If that ratio is high, lenders will hesitate to let you borrow more against the home’s value.
Here is an example: Your home is worth $300,000, and you owe $150,000. If you divide 150,000 by 300,000 you get 0.50, which means you have a 50% loan-to-value ratio. A lender that allows a combined loan-to-value ratio of 80% would grant you a 30% home equity loan or line of credit, for $90,000.
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