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Updated on Friday, January 18, 2019
A home equity loan helps you turn your home into cash — without selling the property. The loan provides cash to help with renovations, a down payment on a second property or unforeseen expenses and can even help you consolidate credit card debt.”You can take a home equity loan for a variety of other reasons, but first ask yourself: What are your other options for financing?” asked Tendayi Kapfidze, the chief economist at LendingTree, MagnifyMoney’s parent company. While home equity loans help in a number of situations, they do require taking a risk: You will have to put your home up as collateral.
Assuming you’re comfortable with that risk — and able to afford the loan payments — here’s how to determine how much money you can take out.
First, you need to understand exactly how much equity you have. To do this, subtract the amount you owe on your mortgage from your home’s market value. The best way to know your home’s market value is by hiring an appraiser, but local realtors may also be able to help you determine a number and internet research may help you find a ballpark value — although you should always confirm the number before moving forward.
Let’s say your appraiser says your home is worth $250,000, and you have $150,000 left on your mortgage. That leaves you with $100,000 in equity. Most lenders limit loans to 85% of your equity, so you would be able to take out a $85,000 loan.
Here are five ways to leverage that equity.
Renovations can be extremely costly. A midrange kitchen remodel costs an average of $63,829 — that’s a lot of cash to save. And sometimes, homeowners aren’t able to plan ahead: Roof repairs or replacements can cost anywhere between $5,000 and $25,000. Even the healthiest emergency funds may not cover that sudden expense. If your home is in need of repair or renovation, a home equity loan may be an excellent source of funds.
But how can you know if a home equity is right for your renovation? When you meet with your appraiser or realtor to determine your home value, ask how that value might change with your planned renovations. Knowing the market value of your property after alterations is essential when determining if you should take out a home equity loan.
Some renovations increase your home value considerably. For instance, adding a wooden deck costs an average of $10,950 and is estimated to recoup $9,065 when you sell your house — that’s almost an 83% return on investment. You can even deduct some home equity loan interest on your taxes when performing home improvements, saving you even more money.
If you’re planning to sell your home in five to 10 years, a home equity loan is a smart way to affordably increase your home’s value. You’re using home equity to build equity. And, if you’re preparing your home for immediate sale, the loan can help you make essential updates and repairs designed to entice buyers and increase the asking price. Pay the loan off immediately after closing to avoid paying interest.
But some renovations won’t nearly recoup their value. That $63,000 midrange kitchen renovation may only increase your selling price by around $37,000. That doesn’t mean a home equity loan is a bad choice. If the renovation will increase your quality of life and you expect to stay in the house for decades to come, pulling from your equity may be the right decision.
The cost of college education keeps rising — and if you have a high school senior on the verge of moving out, you may start eyeing a home equity loan with interest.
A home equity loan offers a lower interest rate than many student loans, especially if you have good credit. Student loan rates are set directly by the federal government. The Direct PLUS Loan — the only loan available for parents — is currently fixed at 7.6% interest. If you’re funding your own education, direct loans begin at 5.05% for undergrads. Interest rates for private loans will likely run higher.
Interest rates for home equity loans of $100,000 may start as low as 4.25%, as of this writing. If your lender offers an interest rate dramatically lower than the federal government’s, using a home equity loan to cover the cost of education may be a smart idea.
Before borrowing, make sure you understand the loan’s terms and monthly repayment expectations. Direct PLUS Loans, for example, offer repayment periods of 10 and 25 years. For a home equity loan, this time period can vary between five and 30 years. A short repayment period may make the monthly payments insurmountable, so be sure to run the numbers against your budget before committing because going into default on a home equity loan is riskier than on a standard student loan. With a home equity loan, your home is collateral. If you fail to repay the loan as agreed, the lender has the right to foreclose on your home. That’s a big risk.
Up to $2,500 of student loan interest can be deducted on your taxes, but home equity loan interest cannot be deducted unless it is used to renovate your home or buy a new one. If interest rates are near-even, this tax break may be the deciding factor that pushes you toward a standard student loan.
Consolidate credit card debt
When your debt feels tall as a mountain, a home equity loan may feel like an attractive option. And sometimes it’s true — a home equity loan can make debt manageable. Instead of making multiple smaller payments to various creditors, you’ll make one single payment. And the interest rate for home equity loans is often significantly smaller than your credit card’s rate.
Doing the math is the best way to determine if this strategy suits your situation. In the short term, the lower interest rate will almost always save you money, but if you consolidate your debt into an affordable 10- or 20-year home equity loan, you may pay more in interest fees than if you paid off the credit card in a decade or less.
The biggest risk is, of course, your house. Falling into delinquency on a home equity loan means the creditor can repossess your property. With credit cards, it’s only your credit score or bankruptcy you have to worry about — and in many cases, bankruptcy doesn’t automatically mean losing your home.
If you’re considering this option, consider negotiating with your creditors first. They may offer a reduced payoff rate or be more willing to work with you on monthly payments if you tell them you’re considering a home equity loan. Handling credit card debt with the issuing company should be a first resort before putting your house on the line.
Americans pay a collective $3.4 trillion each year in medical expenses. If you’re burdened by a surprise medical expense, a home equity loan may help you dig out of debt, but think carefully before taking this option.
If you can’t afford to pay medical expenses out of pocket, a home equity loan can prevent the account from going to collections, which can have a major impact on your credit score. The three major collection agencies — Experian, Equifax and TransUnion — offer a six-month grace period before your medical debt becomes a permanent addition to your credit file. But if you can’t figure out payment in that period, your credit score will drop.
Before taking out a home equity loan, talk to your creditor. Medical offices are often willing to reduce your debt or negotiate a payment plan if they know the debt may be headed to collections. But if they’re not budging, your alternatives may be limited.
Down payment on second home
Tapping into your home’s equity to expand your real estate portfolio — or buy a home — may be a good way to fund a sizable down payment. And, unlike when consolidating credit or paying off medical expenses, the loan’s interest is tax deductible.
Whether it’s a smart idea “depends on how much equity you have,” Kapfidze said. “If you have 100% equity and take out 20 or 30% of that equity, it’s a good idea. You have to evaluate it holistically with all of your other financial obligations.”
It also depends on if you’re buying property to rent or to live in. Rental mortgages typically require a higher down payment — 15% to 20% for a single-family home and 25% for a multi-family property.
Taking out a home equity loan can help you cover the gap between your savings and the increased down payment. And the additional income will help you pay back the loan — but run the numbers first. How much can you charge in rent, and will that be enough to cover both the second mortgage and the home equity loan? What if the unit is unoccupied for several months in a row? If you can’t repay the loan, you’ll lose your first home: Is that a risk you’re willing to take?
Home equity loans can be a way to leverage your current home for some much-needed cash. As interest rates rise, pay attention to the loan terms and make sure that alternative financing methods, like traditional student loans, aren’t a better option. But as long as you can afford the monthly payments and are comfortable putting your house up as collateral, these loans can help you stay afloat in a number of situations.
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