Buying your first home is a huge milestone in life and brings with it many benefits like accomplished dreams, a better neighborhood and greater convenience. However, one benefit that many home-owners overlook is a potential savings account.
This savings is created in the form of home equity. Equity is the total value of your home that you own. This is based on the level of down-payment made each month. When the market price of your home increases, so does the equity and ultimately the value. This equity can be used in many different ways. Here are a few tips and misconceptions about home equity.
Read Up On Tax Laws
The Tax Cuts and Jobs Act introduced in 2017 brought numerous regulatory changes on taxes including those associated with home equity loans. The first change is on the interest of the tax-deductible on the equity. The new rule says that the line of credit on the loan is only eligible for a tax deduction if the loan is used for the improvement of the home.
The second change concerns the interest deduction. As of 2017, interest deductions are only available for homes that have a mortgage of $750,000 or less. However, statistics show that the average home mortgage in the U.S is $260,000 so this law will not affect a majority of Americans.
Choose The Right Type Of Loan
There are two ways to take out a loan on your home so you will need to assess your current situation before you decide which option is best for you. A home equity loan lets you borrow an amount of cash equivalent to the value of your home. There is a fixed interest rate attached to the amount.
The second type of loan is called a HELOC and works like a credit card. It offers a line of credit on an as-needed basis for a certain amount of time, five years for example. This is followed by a repayment period of ten years. The interest rates can fluctuate based on market conditions.
Limit The Use Of Equity
If there's one thing we learned from the financial crisis of ’08, it’s to limit your use of equity. During the housing bubble, many people took out loans on their home equity to finance everything from home renovations to gambling. When this spending got out of hand, it led to a housing market crash.
Therefore, taking out an equity loan is not the best way to finance expenses like home renovations. If history tells us anything, it’s that creating a savings account is the best way to fund these expenses. Although renovating your home can increase its value, you will only receive a part of the money spent in the form of revenue. For example, for every $150 spent, you may only be able to recoup $100 in returns. Limiting your use of equity is a wise financial move.
Know Your Risks
When taking out a home equity loan, it is important to remember that it comes with a lot of risks. In the event that you are unable to repay the loan, the lender could foreclose your home. Moreover, many loans come with a variable interest rate which could be significantly higher when you decide to repay the loan in the future. A good way to overcome this problem is to pay off the principal amount to avoid increases in the rates.
Many people say that real estate is a good investment but no one knows for sure if the value of properties will continue to rise in the future. If the housing market crashes, you will need to repay an amount that is higher than the value of your home which could put you in serious financial jeopardy. Hence, it is important to consider the risks before you take out a home equity loan.
Make Home Improvements
If you need to make home improvements, a great way to do this is with an equity loan. Many lenders are happy to assist you with a line of credit for this because any modifications to the home tend to increase the property value.
You can even take out a second mortgage to finance the home improvement as it can increase the resale value of your home. Research shows that the value of using home equity loans for improvements is 64 cents on the dollar if the home can be sold within a year.
Increase Your Mortgage Payments
It is always a good idea to increase mortgage payments, especially if you have the financial means to do so. However, it is important to pay down the principal first so that you are not bogged down by high-interest rates.
There are a couple of ways to increase mortgage payments. You can either add an extra amount to your monthly payment and increase the amount regularly or alternatively, you could make bi-weekly payments instead of paying once a month. A third way is to automate payments so that you never miss out on a mortgage payment.
Keep The Home Loan Below 80 Percent
An important metric that many lenders use to assess how much money to lend is the loan-to-value (LTV) ratio. This is calculated by dividing the total amount borrowed by the value of the property. This method is used for mortgages as well as equity loans.
As a rule of thumb, it is important to keep the loan debt to below 80%, that is there needs to be at least 20% in equity at any given time. If the loan goes above 80%, you will need to take out mortgage insurance which can increase costs. Alternatively, if you need to sell your home an equity loan below 80% can help reduce losses.
Check Out All Your Options
Different financial institutions can offer different terms and rates on the loan so it is important to look at all your options before making a decision. When taking out a home equity loan, make sure to get a price from your current financial institution as well as other banks and a credit union. There's a good chance that the rates and conditions on the loan may vary.
Alternatively, you can also consider taking out a HELOC which comes with a variable interest rate. In this case, you will need to consider the current interest rate along with the maximum cap on the interest rates.
HELOC Is Not The Only Type Of Loan Available
HELOC is one of the most popular home equity loans but there are other options as well. Instead of home equity, you could take out a second mortgage on the property. This is an individual loan that comes with a fixed income rate so you are not faced with the risk of a fluctuating interest rate.
Another option is to refinance your home. Many people decide to refinance their home if they are in need of immediate cash or if the current interest rate on the mortgage is higher than the HELOC rates. However, the process of refinancing is incredibly complex.
Get A 15-year Mortgage
A 15-year mortgage with a repayment period of 30 years allows you to take advantage of low-interest rates while saving more money. This is because you pay interest for a lower period of time. However, on the flip side, the monthly payments towards the loan will be higher.
As a homeowner, the best way to increase your equity is to pay off your mortgage as quick as possible. A 15-year mortgage means that a greater amount of the payment is made towards the principle and not the interest. You can then take out a larger equity loan to finance home improvements.
Find An Equity Loan With No Closing Costs
Many mortgages come with closing costs which is generally 3-5% of the cost of the home. If the value of your property is high, this can put a serious dent in your finances. Only a few of these costs are legitimate and a lot of them could be going towards junk costs. However, one of the many benefits of an equity loan is that most of them don't come with closing costs.
Hence, if you come across a home equity loan with no closing costs, it would be best to apply for it even if you don’t need one. This way, you are able to take advantage of low-interest rates at no extra costs.
Choose A Larger Home Equity Loan
The higher the home equity loan, the lower your interest rates will be. Many home-owners are hesitant to take out money that they don't need but it can pay off in the long-term. While you may not have an immediate need for the money, you can use the loan amount to repay the loan to keep your interest rates low. The line of credit is still available even after you have paid off the loan.
However, you need to check with the lender if this is permitted because some financial institutions can charge penalty fees for repaying a line of credit too soon. However, if this is allowed it can prove to be a useful financial strategy.
Consider Your Retirement Plans
A home equity loan gives you instant access to a large amount of cash but financial advisors warn homeowners to be careful with how they spend this line of credit. Essentially, an equity loan should be used for house improvements, debt consolidation or for investments. In other words, something that will generate revenue in the future.
For many, an equity loan is a great way to save for retirement. You can put the money in an IRA Roth account where it will continue to grow with interest. A financial advisor can recommend the best ways to allocate your income from the equity loan.
A Low Credit Score
Your credit score is the number the determines your eligibility to get a loan. It is based on your ability to repay previous lines of credit. For example, if you took out an auto loan and made the monthly payments on time, the credit score increases.
However, when it comes to a home equity loan, it is easier to get a loan when your credit score is low. This was one of the major reasons for the housing market crash in 2008. If you are unable to borrow a loan from a financial institution, you can consider getting a home equity loan at a favorable rate.
You Don't Need To Own A Home For Several Years...
It is a common myth that home equity loans are only available to people who own homes for several years. However, this is a gross misconception as an equity loan is available to some homeowners as soon as they make a down payment.
As the value of the home increases, the line of equity continues to grow with each mortgage payment that is made. This money can be a means to end the level of debt or make home repairs. Some people may only make payments on the interest and not the mortgage but this can increase the level of interest you need to pay.
Pay For Education
The income you receive from the home equity loan can be used to fund a college education. Many people who borrow student loans find themselves in debt for several years due to the high-interest rates. However, an equity loan comes with a much lower interest rate. Furthermore, using it to pay for education could increase your income bracket.
However, you need to make sure that you can make timely payments towards the equity loan. If you default on a student loan, it hurts your credit score but failure to repay your equity loan could result in foreclosure of your home.
Pay High-Interest Debts
Another great way to use your home equity loan is to consolidate all of your debts which can ultimately lower your interest rates. Debt consolidation essentially means to bring your personal loans like auto loans and student loans under one roof. You can use the money from your home equity to pay this off.
However, before you take this step, it is important to have a good financial strategy in place to pay off the debts. There is also the added risk of running up more credit once the debt has been paid. Additionally, you need to consider the closing costs associated with the equity loan as this can increase the cost of borrowing the money.
Invest In The Stock Market
In addition to paying off your debts, you can invest the money from your home equity loan in the stock market. Many homeowners find this to be a resourceful use of the money as they expect returns on investment to be greater than the cost of borrowing the equity loan.
Every investment comes with an element of risk attached to it, so you need to take this into account when investing. The stock market is constantly fluctuating and you may not always get the expected returns. It is important that you don't throw all your eggs into one basket and have different avenues of investments like real estate or bonds.
An Emergency Fund
Many financial advisors recommend that you keep an emergency fund. This is a portion of your income that is set aside each month to meet any unexpected expenses that may come your way in the future. As a rule of thumb, you need to have three to six months' worth of living expenses in your fund at all times.
For many homeowners, their home equity serves as an emergency fund. Therefore if they need to pay any medical bills, their home equity can help them meet these obligations. Although the equity loan acts as an emergency fund, it is still wise to assign a separate emergency account that you can contribute towards.
Have A Plan
As with most things in life, you need to have a plan of action when it comes to your home equity loan. When taking out an equity loan you need to think about the repayment process. This also depends on the interest rates and period of the loan. Usually, the more time you take to repay the loan, the more money you need to pay as the amount of interest owed increases.
Home equity loans come with many benefits and can help you meet your financial obligations but at the end of the day, it is important to remember that failure to repay the loan can result in losing your home. Hence you need to have a solid plan to repay this loan.