It can be a financial challenge to become a homeowner. But once you make your homeownership dreams a reality, there are plenty of benefits to enjoy.
On the personal side, you can enjoy the ability to make the place your own without clearing decor choices with the landlord and know that you can settle in without the threat of finding a new place at the end of your lease.
Beyond the personal benefits of homeownership, there are also many financial benefits. One of those financial benefits is the ability to build home equity with each mortgage payment. As you build equity, it can become a tool to navigate financial challenges and cover big purchases.
We will explore the potential of home equity loans below.
The basics of any home equity-based loan is that you use your home equity as collateral for the loan. Equity represents the difference between the home’s current market value and the outstanding mortgage balance. For example, if you own a home worth $500,000 and currently owe $100,000 on your mortgage, then your total home equity is $400,000.
Since you are using your home equity as collateral, this essentially creates a second mortgage on your home. With that, falling behind on your home equity financing payments could lead to foreclosure on your home. It’s clear that tapping into your home equity comes with a risk. But for some homeowners, the risk is worth the reward.
Let’s take a closer look at the two common types of home equity financing options: a home equity loan and a home equity line of credit.
With a home equity loan, the process follows the guidelines of an installment loan. With that, homeowners with sufficient equity can borrow a lump sum amount, often at a fixed interest rate, using their home as collateral.
One key feature of a home equity loan is its predictability. Like with other installment loans, borrowers receive a one-time payout and repay the loan over a set period with fixed monthly payments. This stability can be useful for budgeting purposes, providing a clear roadmap for repayment.
However, it’s essential for homeowners to carefully consider the terms and potential risks associated with using their home equity, as failure to repay could result in the loss of their property. In general, it’s useful to think of this type of loan as a second mortgage, which comes with the risk of foreclosure if you don’t follow the terms of repayment.
Unlike a home equity loan, a home equity line of credit (HELOC) operates as a revolving line of credit, similar to a credit card. Homeowners are granted a credit limit and can borrow against it as needed, making it a flexible option for various financial needs.
One notable characteristic of a HELOC is its unpredictable nature. As the outstanding balance is repaid, the available credit is replenished, allowing homeowners to reuse the funds over the life of the line of credit. This makes HELOCs particularly suitable for ongoing projects or expenses with fluctuating costs, such as home renovations, education expenses, or emergency funds.
Interest rates on HELOCs are often variable, meaning they can change over time based on market conditions. Borrowers may have the option to make interest-only payments during the draw period, typically the initial years of the loan. Afterward, a repayment period begins, during which both principal and interest must be paid.
Understanding the terms, including interest rates, draw periods, and repayment schedules, is essential for homeowners considering a HELOC. If you are considering a HELOC, make sure to read the fine print before signing on the dotted line.
When you take out a home equity loan, you can usually use the funds for a wide range of financial reasons. Below is a closer look at some of the popular uses of a home equity loan:
As you can see, there is no shortage of ways to use a home equity loan. But you’ll have to decide if using your home as collateral for this loan is worth gaining access to funding.
Before you dive into a home equity loan application, start by playing around with a home equity calculator.
In order to get the most accurate assessment of your home equity loan options, come prepared with information about your home’s value, your outstanding mortgage balance, and your credit scores. If you aren’t sure what your mortgage balance is, check your most recent mortgage statements. Use a site like Redfin or Zillow to estimate the current market value of your home.
Many financial institutions and websites offer home equity calculators, including Bankrate. It can help you determine how much you might be able to borrow and what monthly payments you should expect. For example, if you take out a $150,000 home equity loan with a 5-year term and a 6.99% interest rate, you might expect a monthly payment of approximately $3,000.
It’s important to note that a lender is unlikely to let you borrow the entire amount of home equity you’ve built. But with a home equity loan calculator, you can get an estimate of how much you might be able to borrow. Take some time to explore your own numbers with a home equity calculator.
Home equity loans are a useful financial tool. But as with all financial products, there are some advantages and disadvantages to consider. With that, home equity loans may be good for some homeowners and not for others.
Below is a closer look at who home equity loans might be good for:
Now let’s explore who home equity loans might not be good for:
HELOCs borrowers a different option than home equity loans. While both tap into the homeowner’s equity, the structure of the financing arrangement is very different. Like home equity loans, HELOCs are suited for some borrowers and not for others.
Below is a closer look at who a HELOC might be good for:
Now let’s explore who a HELOC might not be good for:
A home equity loan isn’t the only solution for homeowners looking to fund an expense. Below are some other popular financing options:
Every lender sets its own minimum credit score requirements, but many lenders set a minimum credit score of 620 for homeowners seeking a home equity loan.
In general, borrowers with better credit scores can tap into better loan terms. Depending on the situation, a borrower with a great credit score could unlock a lower interest rate that saves them thousands of dollars over the course of the loan term.
If you decide to take out a home equity loan, it’s important to manage the process efficiently. Below are some best practices to keep in mind:
A home equity loan is one option for homeowners who have built significant equity in their home. With this type of loan, homeowners can get their hands on much-needed funds. The catch is that your home equity serves as collateral for the loan, which means you could lose your home if you don’t keep up with the payments—so choose wisely when deciding if a home equity loan is right for you.
What do you think about home equity loans? Let us know or ask us a question in the comments below.