Home Equity Financing: An Attractive Alternative
Simply put, home equity financing is using your home’s equity. This “equity” is the difference between what your home could sell for and what you owe on the mortgage. If you’ve built up a substantial amount of equity, you may want or need to use it to cover the cost of a major purchase.
Before you approach lenders, you should know the amount of equity you have built up over time in your home. Subtract the amount you still owe on your mortgage, along with any other loans against your house, such as a second mortgage or other credit lines, from the market value of your home. The result represents the dollar value of equity. For example, if the market value of your home is $400,000 and your mortgage obligations total $225,000, the available equity is $175,000.
This number is used to determine your loan-to-value ratio. As the name implies, the loan-to-value ratio indicates how much of your home is still being financed compared to its value. The higher the ratio, which is represented as a percentage, the more debt you’re carrying. The lower the ratio, the less debt you have. Our homeowner’s loan-to-value ratio is 44 percent.
Lenders look at the loan-to-value ratio to determine how much more debt you can comfortably afford to take on when you apply for home equity financing. Keep in mind that most lenders will only let you borrow up to 80 percent of your equity, although some will lend up to 90 percent, so that you’re not maxing yourself out in terms of debt, which can impede your ability to pay. In the example noted above, 80 percent of your equity would be $140,000, the maximum amount a lender would consider.
If your house has increased in value since you bought it, you may have built up more value than you realize. If you aren’t sure of the value, you can get a good idea by researching comparable sales in your neighborhood. Online sites such as Zillow or Trulia will estimate your home’s worth, as well.
If you are in the market for this type of financing, it is best to shop around, since interest rates will vary from one financial institution to another. Lenders will look at your personal situation in addition to standard requirements. You will most likely need a credit score of at least 620, have a good record of credit, verifiable employment and income, and of course, sufficient equity in your home.
The financing can be set up as a loan or a line of credit, also called a HELOC, or home equity line of credit. With a home equity loan, the lender advances you the total loan amount up front, usually with a fixed interest rate, fixed payment and fixed term; on the other hand, a home equity line of credit provides a source of funds that you can draw on as needed, similar to a credit card, with an interest rate that fluctuates with the market. Most HELOCs also allow interest-only payments. If your lender has a small limit they will consider, such as $10,000, qualifying for a higher HELOC may be the way to go; that way, you can draw only what you need at the time.
As always, responsible borrowing is the best course. Home equity loans and lines of credit should not be used frivolously. If you are using the money to take a vacation in Hawaii, you could find yourself in trouble down the road, since it will be easier to do again and again, putting yourself in the unfortunate situation of not being able to pay off the ever-increasing loan.
On the other hand, if you are using the money to enhance your education or to make necessary repairs to your home in order to increase its value, that would make fiscal sense. Some people even use their home equity loans or credit lines to buy into the stock market, because their return could go as high as 10 percent, while their credit line is only costing them 4 percent. That might be a risky venture, indeed, but seasoned investors accept the risk and they know they are in a position to cover their losses.
It’s best to keep in mind that this type of financing is secured by your home, so tread very carefully when putting your home on the line. This also explains why your interest rate is so much lower than a typical credit card, which is unsecured.
Finally, check with your tax advisor first, but the interest paid on most home equity loans and lines of credit are tax deductible, providing yet another reason to use this attractive method of financing over a traditional credit card with higher interest rates. ■
Sources: bankrate.com, calcxml.com and consumersadvocate.org.