Home Equity Basics

Highlights

  • Consider using your home equity to finance a major necessary purchase.
  • Understand the risks you take, whenever you lessen your equity stake in your home.
  • Do the proper research to find the right loan product for your needs.
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Home Equity Basics

Purchasing a home is a huge life event. Buying your home is likely the biggest purchase you will ever make. Your home is more than a place to live and to raise your family. It's also an investment.  As time passes,  you hope that the value of your home will increase. If and when the time comes to sell, you hope that you will  find that you can get more money for your home than what you originally paid for it; yielding you a profit.

The resale value, or even the appraised value before a sale, of your home is not the only value your home contains. When you purchase a home and make payments on your home mortgage, you start building what is called home equity. Home equity is the difference between the current value of a home and the amount still owed on the mortgage. As the principal balance on your mortgage decreases, as a result of  your monthly mortgage payments,your home equity increases. This is true, as long as the value of your home does not decrease. So, you can build home equity from an increase in the sale price of a home and from paying down the mortgage debt that you owe on your home.

What is the Value of Home Equity?

Home equity is a valuable asset. Home owners can borrow against their home's equity to pay for home repairs and renovations, school tuition, costly medical expenses, and even pay off debt. Your home equity can provide you with financial opportunities not otherwise available, especially given how hard it has become to get an unsecured loan.  Home equity is a significant advantage to purchasing a home and a great financial resource to have. You never know what life will throw at you. It's always good to have a "nest egg" of readily available built up capital to turn to if you're faced with a financial crisis.

How do I use My Home Equity?

If you want to use your home's equity to finance a major purchase, such as a home-improvement project or to pay for you child's  college tuition, you first need to apply for a home equity loan. A home equity loan is a loan based on your home equity. There are two types of home equity loans: 1) a second mortgage (a.k.a. traditional home equity loan); and 2) a home equity line of credit loan. A second mortgage home equity loan (HEL) is a loan where the lender lends you a lump sum, based on your home's equity, and interest starts accumulating once the loan is issued. A home equity line of credit loan, however, is a loan where the lender presents you with a debit card or checkbook that you can use to make purchases. Just like a second mortgage, the amount you can spend is based on your home's equity. But unlike a second mortgage, interest on a home equity line of credit loan doesn't start accumulating until you make your first purchase with the card/checkbook.

Which type of loan you choose is up to you and your specific financial needs. In general, HELs are a good choice when you are looking to finance a major one-time cost (e.g. a home improvement project with a fixed budget). HELOCs are a good choice, when you either are not sure how much you need to spend in total or when you know that you have to spend a lot periodically (e.g. paying college tuition costs at the beginning of each college year). Both loan types are primarily low interest loans and, for most home equity loans, the interest you pay is tax deductible.

It is important to know that when you take out a home equity loan, you take one a serious obligation. The lender can reposes your home if you default on your payments. In other words, if you don't pay your home equity loan in full or default on too many payments, the bank or lender can take away your home and use its current value to cover what you owe. It is crucial that you maintain your loan payments.

Purchasing a home is a costly venture. While owning a home is a major component of the American dream, it is not always the wisest financial decision. The same is true for borrowing against the equity in your home. Make sure to weigh the positives and the negatives carefully, before taking out any loan or making any major financial decision.

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