As the housing market continues its recovery—and indeed, heats up in some markets—home values are rebounding. One advantage of increasing home values is that for many homeowners the equity in their homes has also increased. Utilizing the equity can be an effective tool with a variety of uses.
This may be a blessing in light of the fact that there continues to be a shortage of homes available for sale. Housing inventory is tight, and most experts believe the market will remain that way for several years. This has pushed prices up so some people may opt to improve their current home instead of purchasing a new one, especially if they’re unable to get into an area they like at a price they can afford.
What is home equity?
The equity in your home is the difference between what your home is worth versus what you owe on it. For example, if your home is worth $200,000 and your mortgage balance is $120,000, you have $80,000 in total equity. Some financial institutions will allow you access to all of it, while others allow you a percentage of it, say 80 percent.
Home Equity Line of Credit (HELOC)
You can get a home equity loan for a fixed term at a fixed rate of interest. However, the more popular option to access equity is through a HELOC, a line of credit which works much like a credit card. As you pay back the amount you borrowed, it becomes available again as part of the line of credit. You can borrow as much as you need up to the maximum amount of your credit limit.
One feature of a HELOC is that it gives you access to funds but you don’t have to use all of it. As an example, if you qualify and secure a HELOC of $50,000, unlike a fixed loan where you would take the entire $50,000, the HELOC allows you to draw only what you need. And your interest is calculated on the amount that you withdraw or borrow.
Because a HELOC is a line of credit, you make payments only on the amount you actually borrow, not the full amount available. The interest charged is also on the amount you borrow, not the entire credit limit available.
A HELOC has several advantages over other types of personal loans.
• HELOC loans generally have lower interest rates compared to other types of loans.
• It’s easier to access a HELOC loan because your home serves as the collateral.
• HELOC loans can come with a fixed or variable interest rate. The variable rate is usually lower but is for a shorter term, after which it may reset to a slightly higher rate.
• With most financial institutions, even if you start with a variable rate HELOC, you can opt to convert it to fixed rate when you’re ready to pay it off.
• A HELOC can offer tax advantages. The interest you pay may be deductible under certain circumstances. Consult an accountant or tax adviser for details.
You can use your HELOC for almost anything, but most people tend to use it for larger expenses, such as a home remodel, a vehicle purchase, college expenses, or even placing a down payment on a vacation home. It can also be used to consolidate other debt. For example, you can pay off credit cards that may be charging a higher interest rate.
The Fine Print on HELOCs
HELOCs require you to use your home as collateral for the loan. In other words, you are taking out a second mortgage on your home. This may put your home at risk if your payment is late or you can't make your payment at all. If you sell your home, you have to pay off your HELOC line of credit at the same time.
HELOCs also come with a draw period and a repayment period. The draw period is when you can actively make withdrawals from your line of credit. During this time, you may make interest-only payments on what you have borrowed. Once the draw period ends, you will be required to make principal and interest payments, which at times may be much higher than just paying interest.
Another point to remember is that HELOCs have a variable interest rate. That is, the interest rate is based on the prime rate, which can change over time. Some financial institutions, like UW Credit Union, will allow borrowers to convert a portion of a HELOC to a fixed rate loan. If you’ve withdrawn $10,000 from a HELOC which has a limit up to $50,000 and you decide that you don’t want a variable interest rate on the borrowed amount rate which may increase, you can request that the $10,000 be converted to a fixed interest rate loan. That still gives you the ability to maintain a HELOC with a borrowing limit of $40,000.
Such options, along with the fact that you can use a HELOC for many purposes, make it a very flexible way to access the equity in your home.
Ken Carlson is associate vice president of Consumer Lending at UW Credit Union.
UW Credit Union