How to Grow and Use Your Most Valuable Asset
For many of us, the opportunity to build equity was one reason for buying a home. Despite today’s uncertain real estate market, your equity could still become one of your most valuable assets over your lifetime.
Here's what we're going to cover:
- The five pillars of equity
- Whether you should use it once you’ve got it
- The types of home equity loans and how they work
- How to compare home equity loans
The Five Pillars of Equity
At first, your down payment is all the equity you have, unless you snagged your house for less than true market value. Broadly speaking, there are two ways to build on that: the debt can go down, and the property value can go up. Specifically, equity has five pillars:
- Monthly payments. Simply making your monthly payments will slowly build equity. In fact, mortgage payments are sometimes referred to as “forced savings.”
- Extra payments on principal. You’ll build equity faster — and pay off your loan earlier. Plus, you’ll cut the total interest you pay over the life of the loan, especially when you pay the extra early on. The math can be quite motivating, so here’s a calculator. Make sure your extra payments do go to principal — check your monthly statement. If your loan servicer hasn’t provided a clear way to indicate how you want extra payments applied, get in touch with them first.
- Good maintenance. Keep your home pristine, and you’ll preserve and possibly increase its value. (See Smart Start’s lesson on home maintenance.)
- Home improvements. Note that some projects add more market value than others. (See Smart Start’s lesson on renovation for ones that usually have a high return on investment.)
- Appreciation. This happens effortlessly, when your home’s value increases in a rising market. But even in hot markets, it’s not a sure thing over the long term. Here’s an Investopedia article on the realities.
Once You’ve Got It, Should You Use It?
Any use of your equity deserves serious thought. Unless you’re using it to buy a different home, you’re reversing the equity-building process and increasing your debt. It’s also important to remember that when you tap equity, your home is the collateral: the lender has the right to foreclose if you fall behind on your payments.
Home improvements? Maybe.
Putting your equity back into your home can be a good call, especially when you’re making key repairs or doing renovations that add market value. Many financial experts say it’s the only reason to use equity.
You might have other loan options that don’t risk your home and have a lower interest rate. Many cities and nonprofits offer low-cost loans for repairs and rehab, so it’s smart to check on what’s available in your area before taking on a traditional bank loan. See Smart Start’s lesson on renovation.
Credit card debt? Not so fast.
Some homeowners turn to their equity for debt consolidation, including paying off credit cards. It’s true that a home equity loan will have a lower interest rate, but there’s more to consider:
- You’re not paying off the debt, just moving it around. It’s such a common syndrome that lenders have a name for it: “reloading.”
- It doesn’t change the habits or circumstances that got you into debt.
- Credit card debt is unsecured debt — it’s not guaranteed by any physical collateral. So if life takes a turn and you default, it’s harder for them to come after your house (although they can try; state laws vary). That changes if you pay off the debt with a home equity loan.
If your debt feels out of hand, a good first step is to talk to one of our homeownership advisors.
Student loan debt? Slow waaay down.
Like credit card debt, student loans are unsecured, but if you pay them off with a home equity loan, your house will be on the line. Plus, you won’t eligible for any federal debt cancellation program that might become available down the road! So weigh this option very carefully. For more on this topic, go to Student Loan Hero.
Home Equity Loan Basics
A home equity loan or line of credit is often referred to as a second mortgage or “junior lien.” As with your first mortgage, you have to qualify and meet the lender’s loan requirements, and you’ll often pay for an appraisal, a credit report, and application fees.
Again, the big thing to recognize is that your home is the collateral. As with your first mortgage, the lender has a lien on your property, meaning a legal claim on it due to the debt you owe them. You could face foreclosure if you fall behind on your monthly payments.
- The loan term is usually 15 years or less
- Interest rates are usually higher than on a first mortgage
- The interest is usually tax deductible (consult a tax accountant)
- There could be maintenance fees
- There could be a fee if you pay it off early
- Can be refinanced later if necessary
- You must pay off the balance if you sell the house
Home Equity Loan
If you need a lump sum to cover a single large purchase, such as a new roof or an addition, a regular home equity loan is probably the way to go.
- Repaid over a set period at an agreed-upon interest rate
- A predictable fixed payment for the life of the loan
- Usually less expensive than a home equity line of credit
Home Equity Line of Credit (HELOC)
A HELOC works more like a credit card. This can be great for a modest renovation or a series of smaller improvements. HELOCs are more complicated and expensive, but if you manage your credit card well, you should do fine.
- Flexibility — you don't have to take out (and pay interest on) a large sum all at once; instead, you borrow and pay as you go
- The interest rate is usually variable* and could go up quite a bit
- An initial advance might be required
- Sometimes there’s a fee every time you draw on the line of credit
- Sometimes there’s a fee if you don’t draw on the line of credit often enough
- The lender often has the right to freeze or reduce your line of credit if your home drops in value or if your finances change
The draw period: How long you can borrow against the line of credit. You can access it any time by check, credit card, or electronic transfer. Once the draw period expires, you can’t borrow any more, even if you didn’t go up to the limit. The minimum monthly payments cover only interest, but it’s smart to pay on the principal.
The repayment period: When the draw period ends, you start paying interest and principal. Remember, most HELOCs are variable-rate, so who knows what the interest might be at the end of, say, a 10-year draw period. Your monthly payment can skyrocket, especially if you haven’t been paying on principal.
Balloon payment? Some HELOCs don’t have a repayment period. Instead, you pay in full (BAM!) at the end of the draw period. Avoid this risky variation.
*The hybrid rate option: Some banks offer a “hybrid” HELOC that lets you convert a portion of your line of credit into a fixed-rate advance. You can even do two or three advances over time, without new closing costs or fees. Learn more at Bankrate.
Homeowners often refinance to get a lower interest rate, which can lower the monthly mortgage payment and save money over the life of the loan. But a “cash-out refinance” is another way to take equity out of your home. See Smart Start’s lesson on refinancing.
Home Equity Loan Shopping Checklist
As with a first mortgage, you have to qualify for a home equity loan or a home equity line of credit, although it will be easier this time around.
Do you have enough equity in your home? Many loan products require at least 20 percent.
Your credit score still counts. As with your original mortgage, a good score can mean a lower interest rate and better terms.
- How’s your CLTV? Most lenders want to see a combined loan-to-value ratio (which accounts for both your original mortgage and the new loan) of no more than 85 percent. To do the math yourself, just divide the total of both loans by your home’s appraised value.
Closing costs, rates, fees, and terms can vary widely. Don’t automatically go to your original lender. Try local banks and credit unions, which often have better deals on home equity loans. Be sure to check on and consider the following:
- Credit report and application fees
- Appraisal fee
- Interest rate*
- Loan term
- Maintenance fees
- Prepayment fees
Lines of credit only:
- Draw period
- Repayment period
- Balloon payment (avoid!)
- Starting interest rate
- Starting interest rate term
- Initial advance
- Transaction fee
- Inactivity fee
- Access (check, credit card, electronic transfer?)
- Can lender freeze or reduce credit
*Note that the APR is calculated differently on regular home equity loans and lines of credit, so the figures can’t be directly compared.