Point of Interest
Home equity loans and home equity lines of credit (HELOCs) allow you to tap into your home’s value to pursue other financial goals, from paying college tuition to renovating your kitchen.
As a homeowner, you might like to know how to use home equity that you’ve built up in your home, or the portion of the home that you own outright, in order to finance some of life’s big expenses, like education costs, medical debt or home renovations. You may not know how to actually borrow against your home equity, though, so we’re here to help you figure that out. Let’s take a look at home equity loans and home equity lines of credit, how they work, and how you can use them to pay for the things you need.
What is home equity?
Home equity, simply speaking, is the part of your home that you’ve already paid for and therefore “own.” If your home is worth $250,000 and you’ve got a mortgage with $100,000 remaining to pay, your home equity is roughly $150,000. As a homeowner, if you’re asking yourself, “How does a home equity loan work,” you can consider it money in the bank which you can borrow against to finance other purposes.
How to borrow against your equity
There are two ways to borrow against your home equity. With a home equity loan, you’re given the money as one lump sum and make fixed monthly payments over the life of the loan to repay what you borrowed.
A home equity line of credit (HELOC) works more like a credit card. You’re given a line of credit with a limit that you can draw from, as needed, for a certain number of years, and you can pay it back and draw from it again. This period is called your draw period. During this time, you only have to pay interest on what you’ve borrowed. After it’s over, you can no longer borrow against your home and you have to start paying back both the principal and the interest.
4 Fundamentals of Using Home Equity
Home equity and HELOC loans can give you much-needed cash, but how does a home equity loan work? See our guide below for the 4 fundamentals of using your home’s equity.
- Choose between home equity loan or HELOC
- Calculate monthly payments
- Use equity to decrease your interest payments
- Limit your use of equity
How to choose between a home equity loan or HELOC
Choosing between a home equity loan and a home equity line of credit comes down to how you want to access your money and how you’d like your payments to be structured. With a home equity loan, your money is disbursed in one large lump sum. This makes it better suited for one-time costs like paying off large bills or consolidating debt. A HELOC, meanwhile, can be borrowed from as often as needed, making it a better choice for ongoing costs like paying tuition.
With home equity loan rates, your payments are fixed, which makes them a smart choice for those who need to keep to a tight budget. HELOCs, meanwhile, allow for interest-only payments during the draw period and a repayment of both the principal and interest later. While this keeps your payments low at first, the payments will go up once you enter your repayment period.
How to Calculate Your Loan Payments
To calculate monthly payment on a home equity loan, divide the amount you borrowed and the interest rate by the number of payments. With fixed payments, you’ll pay the same every month. For a home equity line of credit, during your initial draw period, you’ll multiply your interest rate by the amount that you borrowed. Then, during your repayment period, it gets interesting: you’ll factor in what you’ve borrowed and your interest rate and divide that into fixed monthly payments.
The truth is that doing the math on a home equity loan or a HELOC can get complicated. Your best bet toward figuring out what your monthly payments will be is to use a HELOC-specific calculator, or have your lender work up the numbers for you before you sign on the dotted line.
How to Use Equity to Decrease Your Interest Payments
Another way to leverage your home equity is to use it to consolidate your outstanding debts. This will also help you decrease the amount you pay in total, since less interest will accrue over time.
To do this, start by adding up your total monthly debt payments. Take out a home equity loan in that amount. The home equity loan or home equity line of credit rates will be lower than what you’re paying on credit cards and other consumer debt. Use the lump sum payment from your home equity loan to pay off all your debts. Once those are paid off, all you have to worry about is a singular monthly payment for your home equity loan.
Since the home equity loan is secured by your home, it will likely have a much lower interest rate than other unsecured forms of debt, especially credit cards and personal loans. On the downside, the lender can take possession of your home if you stop making payments.
How to Limit Your Use of Equity
Borrowing against your home is a serious undertaking. After all, when you take out a home equity loan or HELOC, you also give the lender the right to foreclose on your home if you fall behind on your obligation to repay.
With that in mind, it’s important to limit the use of the equity in your home to things that are truly necessary. While it may be tempting to use the money for less important expenses, like that interesting tropical vacation or a big purchase, you would be better served by saving up and waiting until you have the money in hand. While the equity in your home is a valuable tool to have at your disposal, it’s also not one to be taken lightly.
The final word
When used wisely, a home equity loan or line of credit can be an interesting way to leverage the value you’ve got in your home to meet other financial goals. Although you’ll want to be careful when using it freely — because you do, after all, have to pay it back with interest — a loan or line of credit can save you money in the long term by allowing for debt consolidation or help you in other ways.
It’s an infusion of cash that you might not otherwise be able to access, but your home is on the line if you default, so taking advantage of it should be weighed heavily for the pros and cons with your situation.