Here are two ways to use your home's equity to increase its value

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Here are two ways to use your home’s equity to increase its value

A couple discusses a home equity loan with loan officer

If you own your home, you may be able to borrow against your equity. On average, each American homeowner has nearly $200,000 in equity, a significant amount that can open doors to funding for home improvements, educational expenses, and more.

But before deciding to tap into home equity, it’s important to understand how it works and what the options are for borrowing against it. It’s also vital to consider the long-term affordability and the return on that loan. In other words, borrowers should ask if the use of the line of credit will benefit their overall financial position by adding value to their home, and then determine if a home equity loan, a home equity line of credit (HELOC) makes sense.

TD Bank outlines the differences between home equity loans and home equity lines of credit.

 What is home equity?

Home equity is the portion of your home that you own versus what you owe on your mortgage. If you take the amount your home is worth and subtract what you still owe on your mortgage or mortgages, the result is your home equity. Most lenders allow you to borrow up to 80% of your home’s appraised value, but they may allow for greater than 80% depending on other qualifying factors. To figure out how much equity you may be able to borrow, you would multiply your home’s appraisal or worth by 85% and subtract the amount you owe from that number. For example, a home valued at $300,000 would allow for the potential of a $240,000 (80%) home equity loan. If the existing first mortgage is $200,000, then you may be able to access $40,000 from the available equity as a home equity loan or line of credit.

You begin building home equity when you make a down payment on a house; making a larger down payment means you start out with more equity. Your equity continues to grow as you make mortgage payments. If you want to build equity faster, you can make additional payments toward your mortgage principal. And your equity can grow if the value of your house increases, either because you improve the property or because the real estate market in your area heats up.

You can use equity as collateral to borrow money. Borrowing against home equity is often less expensive than taking out an unsecured loan or putting purchases on a credit card.

Home equity loans

One way to tap into home equity is to take out a home equity loan. The amount you can borrow depends on factors like your credit score and income. As mentioned before, it’s typically capped at 80% of your equity. You get the money in a lump sum, and then you make regular monthly payments for a set period of time until you’ve paid it back. The loan is secured by your home, so the lender has a legal claim on the property in case you don’t pay off the loan as agreed. Home equity loans usually have fixed interest rates.

A fixed-rate loan has the same interest rate for the entire lending period, while the interest rate for a variable-rate loan will either increase or decrease over time. Borrowers who prefer predictability may opt for a fixed-rate loan. In comparison, variable-rate loans may have lower starting interest rates and can be a good choice for short-term financing.

How a home equity loan compares to a cash-out refinance

With a cash-out refinance, you take out a new loan that’s larger than your current mortgage. You pay off the mortgage with the new loan, and you get the remainder in cash. You then make monthly payments on the new mortgage. 

You might prefer a cash-out refinance to a home equity loan if you’d like to change the terms of your mortgage, such as to lower your interest rate or extend the length of the loan. But if you don’t qualify for a refinance with better terms, or if you would face higher closing costs with a refinance and want to keep upfront costs to a minimum, you might want to take out a home equity loan instead.

Home equity lines of credit

A HELOC is a line of credit that’s secured by your home. You’re given a credit limit, and you can borrow repeatedly if you don’t go over the limit. HELOCs often have a draw period, which is the time when you’re able to borrow money while paying interest on the amount you’ve borrowed. After the draw period, you may have to repay what you owe all at once, or you may have the option to pay it back gradually during a repayment period.

Your lender provides checks or a credit card that you can use to access funds from your HELOC. HELOCs often come with variable interest rates, so as noted above, the cost of borrowing with a HELOC can rise or fall over time.

Choosing a home equity loan vs. a HELOC

Home equity loans and HELOCs are similar in that they both allow you to borrow against home equity. And you’ll need to provide information about your income and mortgage to apply for either one. But borrowers often use them for different purposes.

A home equity loan gives you cash in a lump sum, so it’s a good choice if you need money for a one-time purchase. For example, suppose you’re buying all new appliances for your kitchen. If you’ve chosen the appliances and you know the total amount you’re going to spend, you might want to take out a home equity loan to borrow what you need all at once. You can then easily budget for the fixed payments to repay the loan.

On the other hand, a HELOC can be used multiple times during the draw period, so it gives you flexibility. This is an advantage if you need to finance ongoing expenses, or if you’re not sure how much cash you’re going to need. For example, if you’re remodeling your garage, you might first pay a contractor to redo the floor, later buy and install new cabinets, and finally hire a painter. A HELOC gives you the option to borrow exactly what you need at each step, so you don’t have to estimate all the costs from the start.

This story was produced by TD Bank and reviewed and distributed by Stacker Media.