Being a homeowner has the added perk of owning equity, or the market value of your home minus the outstanding mortgage and other bills attached to the property. Home equity increases when the property values of the surrounding also area increases. The most effective way of raising home equity, however, is to pay off your principal and mortgage. The sooner you do so, the faster your equity grows.
It can be a source of income or standby funds for major expenses, but it’s not a liquid asset you can dip into anytime. For the benefit of those who don’t know, you can only access your home’s equity if you file for either of these two loans:
- Home Equity Loan – A onetime, lump-sum loan you pay (like a second mortgage) from 5 to 15 years with a fixed interest rate. Be wise in applying for a home equity loan; you won’t be able to borrow more until you’ve paid it off.
- Home Equity Line of Credit (HELOC) – Similar to a credit card, you borrow a certain amountoff of your equity which you can withdraw by small amounts in a given period. Paying off the principal also replenishes your line of credit. For instance, suppose your lender provides you with a $25,000 HELOC. Your initial withdrawal is $10,000,lowering your remaining credit to $15,000.But when you payback the principal, let’s say, at $2,000, your remaining credit then becomes $17,000.
Aren’t these loans tempting? If your credit score is over 700and you have a debt-to-income (DTI) ratio of less than 43% (your debts don’t exceed 43% of your monthly income), then you could qualify for either.
But I urge you to use them only for very important reasons. For instance, if there’s a home entertainment system you want to buy, better save up for that than risk the roof over your head. I would advise against taking out these loans to buy a car, too, unless the loan covers the total price of the vehicle. Otherwise, you’ll be paying car installments on top of your monthly equity loan payments.
So what are the ideal uses for your home equity loan or HELOC? In my opinion, you should use these loans only for expenses that will add value to your home. This way, you can increase your equity even as you borrow off of it.
A home equity loan is ideal if your house needs major repairs. The cost will be significant enough to warrant the loan, but it will be well worth it because it’s for your protection and comfort while you live in the property.
Home improvement projects can also increase the resale value of your home. But make sure the project you have in mind has a high rate of return. Some examples are minor kitchen and bathroom improvements, new insulation, garage door replacement, and attic bedroom conversion.
Consult with local real estate agents soyou don’t waste your equity on renovations and additions that add little to your house’s value.
Real Estate Investment
Another practical use for your home equity is to invest in real estate. You can use the money to put a downpayment on a second property if you plan to flip or put it up for rent soon after. It’s best to buy a property that doesn’t need major renovations or repairs, too, to keep your loan at a minimum.
If you’re planning to rent out the house,the rule of thumb for monthly rent is 1% of the property’s value. This means if a house is worth $255,000, landlords can charge tenants between $2,500 and $2,600 a month for rent.
Here’s my advice: Add your equity loan to the house’s value before calculating the monthly rent. Doing so ensures you receive a profit on top of the sum that will go to repaying the loan.But if you have to go lower than 1% to attract a tenant, I say move on and find a more affordable property to invest in.
Don’t Use Home Equity to Repay Debts
I’ve encountered personal finance websites that say home equity loans are great for paying off credit card debt. Well, I say differently: DON’T use equity to pay debts. I believe it’s better to consolidatethem and refinance for a rate you can afford each month. It may take you longer to repay a consolidated loan, but at least you won’t risk your home getting foreclosed.
Remember, when you take a home equity loan to repay a credit card debt or a bank loan, the lender will place a lien against your house. It becomes collateral which they can foreclose if you’re unable to make your payments.
Your home’s equity is yours to use as you see fit. Make sure to spend it wisely and make sure you can pay it back on time.