Unlocking Home Equity: A Guide To Smart Investing

Home equity is the difference between the current market value of your home and the amount you owe on your mortgage. In other words, it's the part of your home that you own outright. You can calculate your home equity by subtracting your mortgage balance from the property's current market value. For example, if your home is currently valued at $400,000 and you owe $150,000, then you have $250,000 in home equity.

There are several ways to invest equity in your home, including home equity loans, home equity lines of credit (HELOC), and cash-out refinancing. Home equity loans are second mortgages that provide a fixed amount to be repaid over a set period. HELOCs are also second mortgages but offer a revolving balance, allowing you to borrow, repay, and borrow again as needed. Cash-out refinancing involves replacing your current mortgage with a new, larger one and pocketing the difference.

When investing equity in your home, it's important to consider your financial situation and what you want to use the funds for. Additionally, be mindful that borrowing against your equity increases your risk of foreclosure if you're unable to keep up with payments.

Home equity loans

To qualify for a home equity loan, you will generally need a good credit score and a low debt-to-income ratio. Lenders will also consider the amount of equity you have in your home and your income. Typically, you can borrow up to 80% of your home's equity, though some lenders may allow up to 85%.

However, it is important to remember that if you fail to repay the loan, your lender can foreclose on your home. Taking out a home equity loan also means you are adding to your debt and reducing your ownership stake in your home.

Home equity lines of credit (HELOC)

A Home Equity Line of Credit (HELOC) is a revolving line of credit that is secured by the equity in your home. This type of loan is a second mortgage with a revolving balance. You can borrow as much as you need, pay it off, and then borrow again. It works in the same way as a credit card but with significantly lower interest rates. Your payment is based on the amount of credit that you use, not the available loan amount.

HELOCs are divided into two stages: the draw period and the repayment period. The draw period typically lasts between five and ten years, during which you can borrow money up to your credit limit and make interest-only payments. Once the draw period ends, the repayment period begins. During this time, you can no longer borrow against the account and must repay the final amount, including interest, within a specified time, often 10 to 20 years.

HELOCs usually have variable interest rates that can change from month to month, calculated from an index and a margin. The index is typically the US Prime Rate, and the margin is a constant value added to the index. Some lenders offer the option to convert a portion of the variable-rate balance to a fixed-rate loan, which provides more predictable and stable payments.

To qualify for a HELOC, you need to have available equity in your home, meaning the amount you owe on your mortgage is less than the value of your home. Lenders typically allow you to borrow up to 80-85% of the value of your home minus the amount you owe. They will also consider your credit score, history, employment history, income, and monthly debts.

HELOCs can be a useful way to access funds for various purposes, such as home improvements, debt consolidation, emergency expenses, education, business expenses, investments, or retirement income. However, it is important to carefully consider the risks, as failing to keep up with loan payments could result in losing your home.

Cash-out refinancing

Step 1: Determine your eligibility

To be eligible for a cash-out refinance, you typically need to meet the lender's requirements for credit score, property equity, and seasoning. Most lenders require a minimum credit score of 620-680, although some may go as high as 700. In terms of property equity, lenders usually look for 20-30% equity, and there may be a waiting period of 6-12 months after purchasing the property before you are eligible.

Step 2: Gather necessary documentation

You will need to provide various documents, including proof of income, tax returns, bank statements, rental agreements, property insurance, and any other required paperwork. Make sure you have all the necessary documentation ready to streamline the process.

Step 3: Calculate your available equity

Estimate your available equity by determining the current value of your property and subtracting your outstanding mortgage balance. This will give you an idea of how much equity you can potentially access through the cash-out refinance.

Step 4: Shop for mortgage lenders

It is essential to compare rates, terms, and fees from multiple lenders to find the best cash-out refinance option. Be sure to disclose that the property is for investment purposes, as this may impact the terms offered by the lenders.

Step 5: Apply for the refinance

Choose a lender that best suits your needs and submit your application along with the required documentation. Be prepared to provide information about your investment experience and your plans for the cash-out funds.

Step 6: Obtain an appraisal

The lender will order an appraisal to determine the current market value of your investment property and confirm your equity position. This step is crucial in finalizing the loan amount and terms.

Step 7: Await underwriting and approval

The lender will review your application, credit, income, and property information to make a decision on your cash-out refinance request. If approved, carefully review and sign the final loan documents, pay any closing costs, and receive your cash-out funds.

Remember that cash-out refinancing can impact your cash flow and overall returns, so it is essential to consult with a financial advisor or trusted loan officer to ensure it aligns with your investment strategy and goals. Additionally, consider the pros and cons of cash-out refinancing before making a decision.

Home improvements

According to Glenn Brunker, president of online lender Ally Home, "Home equity is a great option to finance large projects like a kitchen renovation that will increase a home's value over time. Many times, these investments will pay for themselves by increasing the home's value."

There are a few things to keep in mind when using home equity for home improvements:

• Make sure the improvements you make will actually increase the value of your home. Some projects offer a better return on investment than others. For example, an upscale bathroom remodel might give you just over a 45% return on investment, while a classic wood deck recoups nearly 83% of its cost. Replacing the garage door offers a whopping 194% return at resale.
• Consult a real estate agent or appraiser to get a sense of what improvements will give you the most bang for your buck.
• Remember that renovations almost always take longer and cost more than initially anticipated. It's important to carefully budget how much you can afford to borrow and how long it will take to repay.
• Shop around for the best loan rates and terms. A home equity loan might be best for a single, short-term job, while a HELOC might be more suitable for a long-term, ongoing project.

Debt consolidation

Pros of Using Home Equity for Debt Consolidation

Home equity loans typically have lower interest rates than credit cards and unsecured personal loans, which can help you save money and pay off your debt faster. A home equity loan can also streamline your payments, making it easier to manage your debt by giving you just one due date to remember each month.

Cons of Using Home Equity for Debt Consolidation

Using your home as collateral puts your home at risk of foreclosure if you fall behind on payments. It also depletes your ownership stake in your home, reducing your assets and increasing your obligations. Additionally, you may have to pay closing costs and other fees associated with the loan.

Eligibility Requirements

To be eligible for a home equity loan, you'll typically need to have at least 15-20% equity in your home and a good credit score, although the specific requirements vary by lender.

Applying for a Home Equity Loan

The process for applying for a home equity loan is similar to applying for a first mortgage. You'll need to know your credit score, estimate the value of your home, and calculate your equity stake. You'll also need to submit paperwork verifying your income, employment, and other financial information. The lender will likely require an appraisal of your home to determine its current market value.

Alternatives to Home Equity Loans for Debt Consolidation

There are several alternatives to home equity loans for debt consolidation, including:

• Personal loans: These typically have higher interest rates but don't put your home at risk.
• Balance transfer credit cards: These offer an introductory period of 0% APR, but may only allow you to transfer up to a certain amount.
• Cash-out refinance: This option replaces your original mortgage and allows you to borrow more, but at a lower rate.
• Debt consolidation loans: These offer rates that can rival home equity rates but have shorter repayment terms.
• Debt management plan: Nonprofit credit counseling agencies can work with you to create a plan to manage your debt without taking on additional loans.

Frequently asked questions