Takeaways
- Home equity is the market value of your home minus your mortgage or other liens.
- Homeowners accrue home equity over time by paying their monthly mortgage.
- Home equity fluctuates based on your home’s market value and mortgage.
- Traditional down payments of 20% gives you immediate equity in your home.
- Tapping your home equity to secure a loan can give you access to cash.
What Is Home Equity?
Home equity is the amount you own in your home. A home equity loan lets you borrow against the equity you have built up in your home through your down payment, monthly mortgage payments, and any extra principal payments. A home equity loan can be very useful for getting cash to pay for a major expense like a home renovation, paying off high-interest debt, or paying for college.
You might live where housing prices have risen since you purchased your home. If you have been regularly paying your monthly mortgage payments, there is a good chance you have accrued significant home equity. Your home equity is an asset that you can tap into and borrow against.
If approved for a home equity loan, you receive a one-time lump sum payment, which you repay over a set term at a fixed interest rate. Unlike a home equity line of credit (HELOC), which works more like a credit card with variable interest rates and a revolving credit line, a home equity loan gives you a fixed amount with predictable monthly payments.
Learn more about how a home equity loan works, how you can use it, and the pros and cons of a home equity loan.
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How a Home Equity Loan Works
A home equity loan, often called a “second mortgage,” allows you to borrow against the accrued equity in your home. This equity serves as collateral for the lender. The amount you can borrow is typically based on a combined loan-to-value (CLTV) ratio of 80% to 90% of your home's appraised value. The loan amount and the interest rate depend on your credit score and mortgage payment history.
Home equity loans have a set repayment term, like conventional mortgages. You will make regular, fixed payments covering the principal and interest. As with any mortgage, if you do not pay off the loan, your home can be sold to satisfy the remaining debt.
Using a home equity loan can be an effective way to convert the equity you have built in your home into cash and leverage your financial position. This can be beneficial if you invest that cash in home renovations, which ultimately increase your home's value even more. However, it is critical to remember that your home acts as collateral for your loan, so it is not risk-free. If real estate values decline, you could owe more on your mortgage and home equity loan than your house is worth.
Read More: What Is a 30-Year-Fixed-Rate Mortgage?
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Home Equity Loan Uses
Applying for a home equity loan can be a smart move. Your home's equity is a valuable asset you can leverage to enhance your net worth or get quick access to cash. Before taking a home equity loan, you must ensure your debt-to-income (DTI) ratio is not too high.
Once you pay off debt and are comfortable with getting a home equity loan, you can consider the practical ways to use a home equity loan:
1. Consolidating Debt
One of the most common uses for a home equity loan is debt consolidation. Debt consolidation combines multiple loans into a single loan and payment plan with a lower interest rate. Debt consolidation makes budgeting easier and might help you get out of debt faster.
2. Starting a Business
If you want to start your own business, access to capital is key. You can use a home equity loan to accomplish that dream as a homeowner.
Unlike new business loans, which usually require an established business history, home equity loans can provide the startup funds you need, without high interest rates. You can use the loan to cover formation expenses, secure an office, or launch a new marketing campaign.
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3. Remodeling Your Home
Another popular reason for taking out a home equity loan is to fund home renovation projects. If you need that extra room, pool, or garage addition to your house, a home equity loan is a great way to reinvest in your property and increase its value.
Plus, if you itemize deductions on your taxes, you can deduct the interest paid on the loan when used for home improvements.[1]
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4. Buying Investment Property
You can also use a home equity loan to purchase an investment property or a vacation home. These properties typically require larger down payments and can be challenging to finance. Using your home equity, you can get the capital you need for a down payment.
Get Smart: 5 Steps to Start Investing in Real Estate
5. Paying for College
University tuition has been skyrocketing for years, and affordability has become a topic of the times. How to pay for college is a constant kitchen table topic.
One way to obtain college funding is to take out a home equity loan. Instead of taking out a high-interest-rate student loan, you can use the funds from a home equity loan to finance your child's college or graduate school.
Related: Private Student Loans: Terms and When It Makes Sense
Advantages of a Home Equity Loan
Using a home equity loan has its advantages, and disadvantages. Here's a breakdown of the advantages of using a home equity loan:
- Predictable Interest Rate: A home equity loan offers a fixed interest rate throughout its term. A predictable interest rate means that your interest rate remains stable no matter how market rates fluctuate.
- Consistent Monthly Payments: Your monthly payments will remain consistent because the interest rate is fixed. Predictability allows you to effectively budget your repayment schedule.
- Extended Repayment Periods: These loans often come with long repayment terms, sometimes up to 30 years. This extended timeline and lower interest rates can lead to more manageable monthly payments and affordability.
- Tax Advantages: If you use the loan for home improvements or repairs, your interest might be tax-deductible, assuming you itemize your deductions.
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Disadvantages of a Home Equity Loan
Now that we have gone over the advantages let's take a look at the disadvantages of using a home equity loan:
- Risk of Losing Your Home: If you fail to repay the loan, your lender could foreclose on your home. Although this is an extreme downside, it is something you should consider as you analyze affordability.
- Minimum Equity Requirement: Typically, you need at least 20% equity in your home to qualify for a home equity loan, though some lenders might allow for 15%. The more equity you have accrued in your home, the easier it will be to secure a home equity loan with favorable terms.
- Closing Costs: Home equity loans come with origination and appraisal fees. These closing costs can add up, making the loan more expensive upfront.
Home Equity Loan vs. HELOC
When you take out a home equity loan, you borrow a lump sum of cash against the equity in your home. You get a fixed amount of capital upfront, which you repay over a set period at a fixed interest rate. This type of loan is ideal if you need a large amount of money.
A home equity line of credit (HELOC) also uses your home's equity but works differently. Instead of receiving a lump sum, you are approved for a line of credit up to a specific limit, which you can draw from as needed (like a credit card). This flexibility allows you to borrow different amounts at different times. It is a suitable option for ongoing or unpredictable expenses.
Smart Summary
One of the most powerful wealth-building assets is a home. Building home equity over the life of your mortgage increases your ownership and, in turn, your net worth. You can tap into your equity to get a home equity loan to help you accomplish your objectives, whether sprucing up your home, adding a room, or building a garage. Choosing the best financing option includes analyzing whether a home equity loan makes sense.
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(1) IRS. https://www.irs.gov/publications/p936. Last Accessed January 15, 2025.
