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Using Your Home’s Equity as a Loan: A Quick Beginner’s Guide

Using Your Home’s Equity as a Loan: A Quick Beginner’s Guide

Real estate is a valuable asset you can use as collateral for a cash loan, but you risk losing your home if you’re not careful. Learn your options and do your homework now.

What’s the secret to using your home’s equity as a loan?

If you have a mortgage, you may borrow against the portion of your home you own to secure cash to make renovations, pay off debt, and more.

Let’s say your home is worth $250,000, and you have $150,000 left on your mortgage balance.

Lenders will let you borrow against the $100,000 you have built up in equity for a lump sum of cash or home equity line of credit (HELOC).

Though it sounds awesome, there are both pros and cons to consider. And choosing the right option to tap your home’s equity makes all the difference.

So let’s start with the basics before you decide the best option for you.

What Is Equity?

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Equity is the amount of money you’ve contributed to owning your home.

It’s the difference between how much you owe on your mortgage and how much your home is currently worth. 

Your equity determines how much you can borrow in a secondary home loan.

Most homeowners have at least 20% equity in their home thanks to their downpayment. 

Steady mortgage payments and property value increases help raise equity. This makes you more attractive and less risky to lenders.

Now let’s see what you can do with your equity.

3 Ways of Using Your Home’s Equity as a Loan

There are three ways you can borrow against your home’s equity:

#1. Second Mortgage (or a Home Equity Loan)

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Taking out a second mortgage is the most common way to tap your home’s equity. 

If you already have a primary mortgage (or the original loan used to purchase your home), a second mortgage works almost the same.

You’ll receive a lump sum of money from the loan directly in your account upon approval. You can use this money however you wish.

Then you’ll make monthly payments with interest on the loan for a set amount of time, or term.

Just like your purchase loan, a second mortgage carries a few expenses during the home closing process. You’ll need to budget for credit checks, appraisals, origination fees, and thousands in closing costs.

Closing costs are usually 2–6%, or between $4,000 and $12,000 for a $200,000 loan. 

Home equity loans 101:

  • Set loan term limits, such as five or 15 years.
  • Usually fixed interest rate so monthly payments remain the same.
  • Pay interest on the entire amount of the loan.
  • Higher interest rates than purchase loans (but still lower than most credit card APR).
  • Must pay off the loan immediately and in full if you sell your home.

A HELOC offers more flexibility.

#2. Home Equity Line of Credit (HELOC)

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A HELOC swaps the lump sum you receive in a home equity loan for a line of credit.

Rather than a one-time deposit of funds, you can draw on this line of credit just like a credit card whenever you make a purchase.

Unlike the strict monthly payments of a second mortgage, you only pay for the amount you borrow from a HELOC. And you only pay interest on what you take out instead of on a giant lump sum.

“Draw periods” last a set term (i.e., five or 10 years). During this time you can borrow money and make small payments.

After the draw period ends, you’ll enter the repayment period. 

You can’t take out any more money during the repayment period. And you’ll need to make larger payments to pay off your loan. You may even need a balloon payment to catch up at the end. 

HELOC 101:

  • “Draw periods” last for a set term (say 10 years).
  • Monthly payments vary depending on how much you borrow and the current interest rate. Only pay interest on what you borrow.
  • Variable interest rate; you’ll pay more/less each month depending on the market.
  • No closing costs.

The final option replaces your current mortgage with a new one worth more than your home.

#3. Cash-Out Refinance

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A conventional refinance replaces your current mortgage with one for the same balance. So if you have $100,000 left on your mortgage, you’ll secure a new loan for $100,000.

The benefit here is the potential to score a better, lower interest rate (among other reasons to refinance your house).

A cash-out refinance gives you a new mortgage for an amount higher than what you currently owe on your home. Then you’ll receive the difference between your outstanding balance and the loan amount in cash.

So if your home is worth $300,000 and your mortgage balance sits at $150,000, you have $150,000 in equity.

With a low-interest cash-out refi, you may secure a new mortgage for $200,000.

Using this example, you subtract the mortgage balance from the amount of the new loan, which in this case is $200,000 minus $150,000. Then you’ll have $50,000 in cash.

Cash-out refinance 101:

  • Refinance your mortgage for more than your home is worth and keep the difference as cash.
  • Potential for a lower interest rate or shorter term with the new mortgage.
  • Slightly higher monthly payments since you’re borrowing more than your collateral (i.e., your home) is worth.
  • Must pay (sometimes hefty) closing costs.

Now that you understand your options, it’s time to do your homework.

Know This Before Tapping Your Home’s Equity

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Take these notes before you sign on the dotted line:

You May Be Able To Deduct Your Loan’s Interest

The interest on your new loan may be deductible if you use the money to substantially improve or build on your home. 

So home improvements make a wise choice for the money you receive from a home equity loan, HELOC, or cash-out refi.

You can raise your home’s appraisal value and lower your taxes at the same time.

You Can Lose Your Home in a Foreclosure If You Don’t Pay Back Your Loan

Putting up your home as collateral for a loan isn’t for the financially irresponsible. 

Lenders can take your home if you don’t make your monthly payments. Then they can sell it to recoup their losses, sometimes for way less than your home is worth.

Only use the equity in your home for a loan if you’re the epitome of creditworthy behavior. 

This means you always make your payments on time and in full. And you know how much house you can really afford so you’ll never risk falling behind.

You Should Boost Your Credit Score at Least 6 Months Before Applying for a Loan

Your credit score plays a huge role in the mortgage and refinance rates lenders offer.

While you may want to start comparing home equity loans now, only the best candidates qualify for the lowest interest rates.

Lenders check your credit history to see how much you owe other lenders and whether you can afford to pay everyone back — including them.

So put yourself in the league of extraordinary applicants by learning what factors make up your credit score. And take at least six months to improve the most important elements.

Low-risk applicants have:

  • Over 20% equity in their property
  • A credit score greater than 620 (higher than 700, ideally)
  • Less than 50% debt-to-income ratio (DTI) 
  • Secure, steady employment

If you put your tax refund to work, you may be able to tackle those ASAP.

The Wrap Up: Using Your Home’s Equity Wisely 

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You should never use your home’s equity to fund a lavish vacation or shopping spree. But it can be a smart choice to raise the value of your home.

If you need cash to pay off credit card debt, medical bills, or student loans, a personal loan may offer better interest rates. You also won’t deal with closing costs or potentially jeopardize your living situation.

Crunch the numbers to see which is best for your situation.
Whatever you decide, start by raising your credit score and you’ll boost your chances of approval either way.

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