A huge benefit of owning your home, even when you have a mortgage on it, is that, over time, you build equity. Equity is simply the value of the property minus the amount you still owe on it. For example, if the value of your home is $250,000 and you still owe $150,000 on your mortgage, you have $100,000 worth of equity. You can use that equity by taking out a home equity loan.
With a home equity loan, you’re usually limited to borrowing 85 percent of the amount of equity you have, according to the FTC. What you use the money for is really up to you. Before you decide to take out a loan against your home, you should understand the different options available as well as the potential drawbacks and benefits.
Types of loan
There are typically two types of home equity loan. The first type is a simple loan. You borrow a lump sum of money and then make monthly payments until the loan is paid off. This is similar to the initial mortgage on your home.
The second type is a line of credit, which is similar to a credit card. You can borrow up to a certain limit but aren’t obligated to take out all the money. You can either access the money with a credit card or by writing checks to yourself from the credit line. Like a credit card, a home equity line of credit (HELOC) is a type of revolving debt. You can take money out during what’s called the draw period, then pay back what you’ve borrowed during a repayment period. Depending on the type of HELOC you have, the draw period might renew after you’ve paid off the loan.
The pros and cons
Depending how you use the amount you borrow, a home equity loan can boost the value of your home. For example, you might use the money to fix up your kitchen or add a garage onto your property, which can then raise the market value of the home.
Another benefit of the loan is that the interest can be deducted from your income at tax time as long as it meets certain requirements set out by the IRS. That can mean that it is more cost-effective for you to borrow against your home for certain upgrades than to use a personal loan or credit card.
Home equity loans do have a major drawback, though. When you borrow against your house, you are using the home as collateral. If you borrow more than you can afford, you risk losing your home if you don’t make payments.
Getting a home equity loan is similar to applying for your mortgage. Prequalify for the loan to see what type of interest rate you’ll receive, and get an idea of the size of loan you are eligible for and can afford to repay.
Image source: Flickr
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