You have bought a two-bedroom house for $300,000 a few years back. Now you have a child and want to remodel the house to make a room for the new baby. Obviously, you will need money to do all that. An early estimate put the entire cost of remodeling at $80,000. Where can you get this sum of money?
Here comes home equity in picture. It is defined as the difference between the home’s fair market value and the outstanding balance of all liens on the property. This simply means you can tap the equity in your home that you have built over the years by paying mortgages on time.
How a Home Equity Loan Works?
Let’s take the example of the house you have bought for $300,000 a few years ago. At the time of closing you put down 20% of the cost of the property, which was $60,000. So, you already had $60,000 in equity when you bought the house.
Let’s assume that you have paid off $100,000 of a $240,000 ($300,000 – $60,000) mortgage. The amount of money to be paid on your mortgage is now just $140,000 ($240,000 – $100,000). Let’s also assume that a recent appraisal has put the value of your home at $450,000.
You can now calculate your current equity in your house. Just take the difference of the latest appraised value of your home and the money you owe on your mortgage. This works out to be $310,000 ($450,000 – $140,000).
A lender can now easily offer you a loan for up to 85% of your equity in the house unless it doesn’t exceed 80% of the loan-to-value ratio. Taking the example, you can be offered a home equity loan of up to $263,500. But you need only $80,000 for remodeling.
It is only prudent not to borrow more than you actually need. Remember you will now have two mortgages to pay off and it won’t be easy to do so if your loan amount exceeds more than you can comfortably afford.
What is a Home Equity Line of Credit?
A home equity loan is not the only option you have when you need to tap the equity in your house. You can consider a home equity line of credit and reverse mortgage as well. While the latter generally requires you to be over 60 years of age to qualify, the former can be a great option if you need small amounts of money quite frequently.
Suppose your child is old enough to go to a college. You need to pay for the tuition fee at the beginning of each semester. A home equity line of credit or HELOC can be an ideal solution in such a situation. It works much like a credit card as you are offered a revolving credit based on the value of your equity in the house.
You can withdraw as much as you need up to the limit of your approved credit, when you need it, with a home equity line of credit. The interest is charged only on the amount that you borrow and not on the unused amount of the credit limit.