Myth: Never Borrow Against Your Home’s Equity
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October 31st, 2016 at 11:00 am

home equity

Most homebuyers–especially first-timers–have been told it’s important to build equity in their place of residence. But not every owner knows what they can or should do with the equity their home has accumulated over the years.

As a refresher, Investopedia defines home equity as:

“The value of ownership built up in a home or property that represents the current market value of the house less any remaining mortgage payments. This value is built up over time as the property owner pays off the mortgage and the market value of the property appreciates.”

Sitting on your home’s equity can certainly pay off when you decide to sell. If you’re moving to a bigger, more expensive home, the equity can help with the down payment and reduce monthly payments on your next mortgage. If you’re downsizing, equity might help you buy a smaller, less expensive home and put your profit to other uses.

What about borrowing against your equity?

Perhaps less frequently discussed are the options of securing a home equity loan or home equity line of credit. Nextavenue.org, a site devoted to educating Baby Boomers, offers these definitions:

Home equity lines are like gigantic revolving credit cards. You can tap as much or as little of the line when you want, often over 20 to 30 years. Best for: A fluctuating expense that’ll last years–like ongoing home improvement projects done in stages or college tuition.

Home equity loans give you a lump sum of money, charge a fixed rate, and must be repaid over five to 15 years. Best for: Someone with a short-term expense, such as a one-time home renovation.

Borrowing against your home’s equity offers distinct advantages vs. using consumer credit cards. However, doing so means your home secures the loan as collateral, which could scare off potential buyers.

Don’t worry too much, says Greg Schulte, our Chief Financial Officer. We asked Greg, a Certified Public Accountant, to discuss the finer points of home equity loans and lines of credit to clear up some of the confusion for you:

What’s the best way to determine the equity in your home?

Contact a Berkshire Hathaway HomeServices California Properties agent and arrange for a free market analysis of your home. You also can go online, but the problem with those types of services is that they use a lot of estimates and make a lot of assumptions that may or may not be true about your house. When you work with one of our agents, you get a specific, professional, and knowledgeable estimate of what your individual home’s equity might be.

Is a home equity loan or line of credit the best way to use your equity?

It depends on your financial needs. They certainly are less expensive than consumer credit via credit cards. If you need access to funds, many times a home equity loan or a line of credit is the best choice. They’re more cost-effective because you get lower interest rates than consumer credit. Even unsecured personal loans from a bank are more expensive than a home equity loan or line of credit. It’s a secured real estate loan, meaning your home is collateral under the second mortgage. That feature allows the financial institution to price the loan more favorably than other forms of consumer credit.

But if you are unable to make your payments, the bank has similar rights as it does under a first mortgage, so it can foreclose. Still, it is behind the first mortgage in terms of priority, so the first mortgage lender would be in a priority position over whoever holds the second.

Many times they’re interest-only payments, and the principal isn’t due until some future period. The interest on a home equity loan or line of credit may be tax-deductible as well. Consult your tax adviser for these specific rules.

Can you ever have too much equity in your home?

If you have borrowing needs, and you’re not borrowing against the equity in your home, you probably are paying too much for your credit. To put it another way, you can’t have too much equity in your house if your home improvements and cash-flow situation are fine and you don’t need any debt. Most people don’t choose to live that way. They live on some amount of debt. Borrowing against the equity in your house is likely the least expensive debt you can get, but there are risks as discussed above.

For example, if you have a house with a value of $500,000 house and no mortgage on it, you have $500,000 of equity. If you’re paying 20 percent on a credit card, you’d be better off putting some debt on your house by getting a home equity line of credit against the value of your house and paying a less-expensive interest rate than the credit card. So it would be better to have debt against your house, although it would decrease your equity. You pay a lower interest rate, but your house is now collateral for the loan.

How much will the lender give you on a home loan equity line of credit?

It depends on your credit score, your credit situation, the amount of equity in your house, the type of loan, your income, debt, and other factors. But typically, if you have good credit and favorable lending parameters, most lenders will lend you up to about 75 percent of the equity in your home.

Which do you think is better to get, a home equity loan or line of credit?

A line of credit has more flexibility. You can draw on it and pay it back as your needs change. You can pay large amounts of principal and interest, or small amounts. It does have a fixed term and a maximum amount you can borrow, but it’s a revolving account, so once you pay it down, you can keep using it. With a loan, you have a set amortization schedule, so you’ll have to make a regular monthly payment.

Should you be concerned if you learn your equity has dropped? What can you do to rebuild it?

If it has dropped, two things might have happened: The value of your property went down, or the amount of your debt went up. There’s a couple of things you could do. Consider improvements to your house to raise its value. Any of our Berkshire Hathaway HomeServices California Properties agents can give you tips on how to make its value increase. Oftentimes, remodeling kitchens, bathrooms and entryways, expanding living areas, and repositioning certain things can raise its value tremendously for pennies of cost on the dollar value to a potential buyer. The other thing you could do is focus on paying down your mortgage by increasing your monthly principal payments. Many loans don’t have early-repayment penalties, but some do, so check with your lender.

Can equity be used for tax purposes?

The interest on a home equity line of credit or loan is deductible subject to certain criteria that are set forth by the Internal Revenue Service and the individual state taxing authorities. Generally speaking, subject to these limitations, you can deduct the interest paid on your home equity loan or line of credit, and your first mortgage. You always need to check with your tax adviser to discuss your individual circumstances.

We certainly don’t expect you to know all of this on your own. That’s why you should work with a qualified Berkshire Hathaway HomeServices California Property real estate agent and our many affiliated services.

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