What is Equity and How to Use It

Feb 5, 2015

What is equity?

Equity is the value of your property minus the debts that are held against it. If you pay down your mortgage by $500, you have an additional $500 worth of equity in your home (assuming the value isn’t less than what you owe on your mortgage). Building up equity is one of the best arguments for owning a home as opposed to renting one. The money you pay monthly toward your mortgage is still yours, and you get it back when you sell the house. If you need cash but don’t want to sell, though, most financial institutions offer two options: a second mortgage or a home equity line of credit.

A second mortgage is a loan that’s secured by your home when you still have a first mortgage on it. If you need a large, fixed amount of money for repairs or other expenses, taking out a second mortgage can allow you to pay for them at a favorable interest rate. This is an option for major planned purchases or for really expensive emergencies.

A home equity line of credit is like having a credit card that’s secured by your home. That credit line can be accessed online or at a branch. Like a credit card, there is a credit limit. In a home equity loan, the limit is usually pegged at the time of opening according to the value of your house and what is still owed on the first mortgage. It’s good for a specific term, called a “draw period,” which is generally 10 to 15 years. Many home equity lines of credit offer the possibility of renewal. In most cases, the time limit is just an opportunity for the lender to reappraise your home, but it’s also an opportunity for you, as a consumer, to take a moment and reconsider your own money strategy before choosing to renew.

The most important benefit of using this line of credit is that the interest is usually tax-deductible. The risk, though, is that failure to repay could result in foreclosure. To avoid that, let’s look at some common mistakes people make with home equity lines of credit as well as some low-risk opportunities they can provide if managed responsibly.

Don’t think of it as “free money”

One of the key causes of the sub-prime mortgage crisis was abuse of home equity loans. People would spend recklessly using the equity in their homes. They expected the value of their property to forever keep pace with their levels of spending. When it didn’t, they found themselves owing more money on their homes than they were worth, and there was not enough credit (or value) in the home to refinance. Spending your home equity to finance your lifestyle is a lot like burning your house down to stay warm in the winter. It’ll work for a while, but you’ll be left without a place to live.

Think of it as an emergency fund

One of the smart money habits of financially successful people is establishing a small pool of savings to pay for unexpected disasters like job loss, car repairs or major illness. Having this savings enables them to avoid going too heavily into debt if one of these catastrophes occurs. You can use your home equity line of credit in a similar way. While it’s not an ideal emergency fund, it’s a far better rainy day answer than credit cards, payday loans,or car title loans.

Use it to start a business

If you’ve been thinking about opening a small business, you probably already know that financing that dream can be a struggle. Your home equity line of credit can help pay for some of your start-up expenses. You can use it in conjunction with grants and small business loans to diversify your risk. The favorable, flexible repayment terms and lower interest rates can make this a viable option for your new venture.

Finance your car

Home equity lines of credit can make car buying far easier. With independent financing, you can negotiate with the dealer more aggressively. The interest rates are also lower. Since you’re more likely to sell your car than your house, owning the car outright can make that process easier, too.

Improve your home

One of the safest investments you can make with a home equity line of credit is remodeling or improving your home. Installing new appliances, vinyl siding or energy efficient windows will pay dividends both in the increased value of your house and in your quality of life. These improvements will increase the value of your home. They will also increase your available home equity, and the money you’ve put into your home will possibly pay off when you sell it.

Considering a home equity loan? Check out our website for our current rates. We’d be happy to review your unique situation and recommend the home equity loan or line of credit that’s right for you.