Home equity is where homeowners gain wealth through living in their home. Equity can go up when the property value increases, and it can go down as you pay your mortgage. You can think about it as the part of your home that you truly own in comparison to your mortgage.
It sounds complicated, but it’s really not. We’re going to break down equity and help you answer the question of “how does equity work?”
What Is Home Equity?
First, think about how much your mortgage was originally financed for and then look at your current balance. The difference is the initial equity that you have in your home. To give you an example, imagine you purchased your home for $$, and your current remaining balance is $$. That gives you $ in equity, but it doesn’t stop there.
Now, imagine that you purchased your home five years ago and since then, your property value has increased to $$$ for your home. That means if you were to sell your home, you could ask for $$$ because it reflects the current property value.
Take that $$$ and subtract your current balance on your mortgage, the $$ , and you end up with a difference of $. That $is considered to be your home equity.
How Does Home Equity Work For Me?
To build your home equity is going to take time, and it can just as easily plummet like many experienced when the housing bubble burst all those years ago. Like everything else, though, if you can hold on to your home through the rough patches, the value will go up again eventually.
Equity can be compared to something like a 401k or savings bonds. The money is there, but you can’t spend any of it without some work. As an example, you can borrow against the equity in your home through something called a home equity line of credit or a home equity loan. Anything borrowed is added to the existing principal.
Another way to access the funds is to sell your home or other property. Being able to access your funds is helpful in case of an emergency or when you need to make immediate improvements to your home. Bonus – you can use home improvements as a tax deduction on your tax return.
What Are The Risks Of Borrowing Against Home Equity?
A line of credit and home equity loans put your home down as the collateral to borrow the money from the bank. That’s a serious commitment to paying off the loan because if you were to become unable to make payments, your house could go into foreclosure.
Something else to consider is the way the property value changes. If you borrow $ against home equity, then your remaining balance of $$ climbs to $$$ that you will have to pay. If your home value drops to $$$, then you owe more than the home would be worth.
If you have to move or sell your home when you’re in that kind of scenario, then you are going to have to face the possibility that you may lose significant money on the sale. The result could be that you won’t be able to move as you wanted.
Obligations for Lines of Credit, Home Equity Loans, and Mortgages
By now, you understand that a line of credit or home equity loan is going to be money taken out against your home. Like your original mortgage, the ramifications are huge if you can’t make the payments. If you’ve ever heard of multiple mortgages, the additional loans on top of the original mortgage are what those are referring to.
The good news is that home equity loans have a much shorter term compared to mortgages. While a 15-, 20-, or 30-year mortgage are standard fare for mortgages, a loan or line of credit is typically going to have a repayment term of just a few short years.
Having the money available in home equity isn’t enough to get a loan or a line of credit. You will have to have your credit checked, and your debt-to-income ratio will also be verified. If your bank or other lender deems you to be worthy, then you’ll qualify for one or the other.
What Is A Home Equity Line Of Credit?
Most people have credit cards and understand that you use a credit card to make purchases that you have to pay off later. A home equity line of credit functions much the same way. They have draw periods or a limited amount of time that you can withdraw funds up to the approved limit.
You can usually choose between an interest-only period or a period where you can pay interest as well as the principal. The first is going to take you longer to pay back while the second option is going to allow you to pay your credit line back at a faster rate.
At the end of the draw period, you have to pay everything back, and you are not likely to be able to renew your line of credit until after it has been paid. You may also be stuck with an adjustable interest rate which can impact the amount you have to pay back.
What Is A Home Equity Loan?
A home equity loan gives you a lump sum that is due back at a fixed rate over a pre-determined time frame. It works similarly to a personal loan except the collateral is your home. You will be expected to pay a set monthly amount to the tune of an included compound interest rate.
Compound interest means that you’ll be paying interest on your interest with each subsequent year. It is not unusual for a loan of $ to result in paying back closer to $ once everything has been paid back.
Home Equity Line Of Credit Or Home Equity Loan?
Deciding if you want a line of credit or a loan is going to depend on why you want or need the funds. If you need money to maybe pay for an extravagant event, like a wedding, and don’t intend to borrow anything else, then a loan is going to be best. It will have an adjustable rate, but at least you’ve only pulled what you need.
On the other hand, let’s say you’re going to help your son or daughter pay for their college tuition every semester. With that in mind, you may want to get a line of credit that you can draw from and pay back as needed for every semester. It allows you to borrow the money as you need it. Smaller amounts that are borrowed periodically also end up costing less than a loan because you can pay them back faster.
What Questions Do I Need To Ask?
When you’re asking yourself how does equity work, you also need to ask yourself a few questions to help you decide how to best use your equity. Decide when you need it and for how long you need to have access to the funds. Credit card consolidation is more of a short-term purpose while college tuition is more of a long-term scenario.
You’ll also need to determine what kind of monthly payment you’ll be able to handle as well as whether or not you can control yourself if you have an open line of revolving credit. Don’t forget to make sure you know your rates, repayment periods, and any other possible consequences.
Missing payments or not paying at all can result in losing your home, so you need to be sure you can reliably make the payments. There may be other restrictions in place, too, like not being able to rent out your home for the duration. Whatever you do, make sure you read the fine print.
Going Forward With A Line Of Credit Or A Home Equity Loan
If you can justify, and with good reasons, why you should dip into your equity, answering “how does equity work” can help you make an informed decision. It’s important to know the possible consequences as well as the benefits of going forward with a home equity line of credit or a loan.
Ask questions, research your market value and current creditworthiness, and then you’ll be better equipped with necessary knowledge before entering a repayment agreement you may or may not be able to live with.