Using Your Home's Equity
You have purchased a home and are making your monthly payments on time, but now you are faced with an unexpected expense that has you thinking about using the equity in your home to cover it. Perhaps it's a leaky roof that needs to be replaced or your dated kitchen or a bathroom that needs to be renovated. Maybe you have some credit cards that you would like to pay off or want to finance your children's college education. Regardless of the situation, using the equity in your home may or may not be the best option for you.
There are two types of equity loans: the home equity loan (HEL) and the home equity line of credit (HELOC). A HEL is a one-sum payment that the borrower repays with a set monthly amount to the lender, very much like a mortgage. A HELOC is a credit account with a maximum you can use with interest attached and you pay back the amount at a variable rate, very much like a credit card. Your balance may be $10,000, but your minimum due is five percent of that. You can choose to pay the minimum, over the minimum, or the total in full.
Home Equity Loan
Home equity loans may be best used for a one-time goal for which payment is due in full and that has long-lasting benefits, such as additionally boosting the equity in your home. As with any thing, there are both pros and cons.
Pros
- You can borrow up to 125 percent of your home's value, minus any existing debt.
- Interest on a home equity loan may be tax deductible if the money is used for home improvements. The IRS allows for the first $500,000 in interest to be deducted.
- Because the loan is secured with your home, the interest rate you pay may be lower than a credit card or unsecured personal loan.
Cons
- Interest rates may be higher than a cash-out refinance or a 30-year mortgage, because the HEL places a second lien.
- Similar to an additional mortgage on your home, this puts your home at risk if you can't make the payments.
- If the value in your home drops, you may end up owing more on your property than it's worth.
Home Equity Line of Credit
HELOCs are often used to consolidate debt or pay for college. Below you will find pros and cons for this option.
Pros
- You can spend as frequently as you need to, up to the limit of your credit line.
- Some of your interest could be tax deductible, but be sure to verify in advance of using this option.
- Most financial institutions charge a variable interest rate, which fluctuates depending on the market rate. If rates are low this could be a pro; if rates are high this is a huge con.
Cons
- Transaction fees may be charged each time you borrow.
- Annual and inactivity fees may apply, depending on the financial institution.
- When you sell your home, you have to pay the line in full.
- After a certain length of time, you will need to renegotiate your line of credit, repay your full line, or set up a new repayment schedule.
- You may have to use minimum or maximum amounts of money each time you draw from your credit line.
- A fee is incurred when you open this type of loan, as well as application charges, and fees for home appraisal, title search, and other legal services may apply.
Risk Factors
Another factor to consider when deciding between a HEL or a HELOC is the loan-to-value ratio. The loan-to-value ratio tells you how much of a property is being financed. It's the best way to tell you how much equity you have in a property. If your home is worth $100,000 and you owe $80,000, then your loan to value loan-to-value ratio is 80 percent. Higher loan to value loan-to-value ratios mean a higher risk for the lender. If you fail to pay your home equity loan and your house is foreclosed on, the bank then has to sell your home at a higher price, making its job more difficult. If a lender thinks long term, they it may be hesitant to lend to you for this reason. If your balance on your home is much lower, say 20 percent, then your chances of being approved may be more favorable.
Workplace Options. (Revised 2022). Using your home's equity (A. Moyer & B. Schuette, Eds.). Raleigh, NC: Author.