Unless you’ve won the lottery, you probably can’t afford to pay for an entire house in cash. For many people, just coming up with enough money to put toward a 20% down payment can be stressful. Still, whatever you are able to put down helps. That amount is part of your home equity and as it grows, it can be turned into cash you can use for other expenses.
Find out now: How much house can I afford?
What Home Equity Means
If you’re not quite clear on what home equity means, here’s an explanation. Say, for example, that you decide to buy a house in a nice neighborhood. The house is worth $300,000. If you borrow $231,000 and choose to hand over 23% ($69,000) as a down payment, that last number represents your home equity. It can be found by subtracting the amount of money you owe your lender from the home’s total market value.
So when you look at how much your home is actually worth, your home equity is the part that belongs to you because you’ve paid for it. As time passes, your home equity increases when your house appreciates or gains value and you pay off more and more of your mortgage.
Let’s refer back to our example. In the year 2018, your home is worth $450,000. By this time, you’ve contributed $15,000 toward your $231,000 mortgage. You only owe $216,000 now and the difference between that amount and your home’s new appraised value is your home equity amount: $234,000.
If your home’s net worth declines over time due to an economic downturn such as a recession, your home equity can end up being a negative number. For the most part, however, your home equity should go up if you can keep up with your monthly mortgage bills.
Related Article: Home Equity Loan Dos and Don’ts for Millennial Homeowners
Why Home Equity Matters
What’s the point? Why should anyone care about their home equity? If you’re unsatisfied with your current home and want to sell it, you can have your equity turned into cash. Then, you can take that money and use it as a down payment for a new house.
And once your equity reaches a certain level, it’s possible to qualify for a home equity loan or a home equity line of credit. Maybe you’re ready to remodel your master bedroom or expand your garage so that there’s room to store your new car. Or perhaps you’re approaching your 40’s and you need an easy way to fund your retirement. Applying for a home equity loan is one way of meeting your goals.
Home Equity Loans
These types of loans come in two varieties. With a traditional home equity loan, your interest rate remains fixed. With a home equity line of credit (HELOC), your loan comes with an adjustable interest rate.
By getting either type of loan, you’d essentially be taking on a second mortgage. Under the terms of a home equity loan, your lender would convert your equity amount into a lump sum of cash money that you could then use for whatever you’d like.
You’d be risking a lot, though, if you lose your job or contract a serious illness that leaves you with huge medical bills. Your house becomes your collateral. That means that by defaulting on your home equity loan, you’re giving your lender the opportunity to seize your home and allow it to go into foreclosure.
The same thing could happen if you have a home equity line of credit (HELOC). The major difference between the HELOC and the standard home equity loan is that with the former type of mortgage, you call the shots and determine how much of the loan to use at one time. Your interest rates therefore can fluctuate on a monthly basis.
Unlike primary mortgages that tend to be paid off over a 30-year period, home equity loans and HELOCs are often used for a shorter amount of time. If you needed another mortgage for short-term projects like remodeling a few rooms in your house and replacing light fixtures, you could try to apply for a five-year loan.
Related Article: Pros and Cons of Tapping Home Equity to Pay Off Debt
Your equity reveals the percentage of your home’s value that you can rightfully claim as your own. If you’re a homeowner, simply making your mortgage payments on time each month is a quick way to build your equity.
Revolving credit usually has more of an influence on your FICO credit score than installment loans do. So if you need a way to finance your child’s college education or your own retirement, using the equity in your house to get a home equity loan could be a better alternative in the long run to taking on more credit card debt.
Also, compared to the rates that are attached to credit cards, your interest rates will likely be lower through a home equity loan. And the interest on your loan could be tax deductible if you meet the criteria outlined by the IRS.
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