Home equity loans are a popular choice for people looking to access a large sum of money with relative ease and at a favourable rate. When done right, home equity loans can be a smart tool you can use to build wealth over time.
Of course, there’s no such thing as a free lunch. Let’s first try to dissect a few of the intricacies that make up this cash-injecting instrument.
Let’s start with what “home equity” actually is, before we get to the loan part.
Your home is a conservative investment. In most real estate markets, its value should gradually increase over time. Fluctuations will happen along the way, but not wildly, like riskier investments tend to do. This increase is called equity, and it’s all yours — almost.
Before we get into the nitty-gritty, here’s a simple way to calculate your home’s equity:
The current market value of the home – what you owe = home equity.
Remember that the market value is what someone is willing to pay for your home. The assessed value is what your property taxes are based on — don’t confuse the two.
Say you have $150,000 left to pay on your mortgage, and the current market value of your home is $800,000. This leaves you with $650,000 in home equity.
Got it? Great! Let’s move on.
There are two ways your equity can increase:
If you’re one of the lucky ones to have built up a sizable amount of home equity, then you have the option to either leave it alone or tap into it. A home equity loan is one way to tap into your home’s equity.
Also referred to as a second mortgage or an equity loan, a home equity loan is an agreement between a homeowner (borrower) and a lender (bank).
How it works:
Under the terms of the agreement, the borrower must:
In exchange, the lender:
“Your home is a conservative investment. In most real estate markets, its value should gradually increase over time.”
Home equity loans work best when they are used for purposes that strengthen your financial situation.
Let’s say you want to renovate your kitchen that looks like it came from the set of a ’90s sitcom. You know this is a good investment because the Property Brothers on HGTV told you repeatedly that “kitchens and baths sell homes.”
You expect these updates to cost you around $30,000, but you don’t have that type of money laying around, so you begin to explore your options. You then recall that your neighbour put an addition on their house by tapping into their home’s equity, and eventually discover that you could do the same.
You decide to apply for a home equity loan to access the capital needed for the renovation; you get approved; and, voilà, you get a new kitchen and (hopefully) a more valuable home. And if you play your cards right, you may even qualify for a tax deduction on the interest.
This is just one way you can use a home equity loan to better your financial situation.
Some other reasons you might want to look into a home equity loan include:
Since home equity loans are there to virtually “use as you wish,” some folks may use them for the wrong reasons. Don’t be that person.
Here are some reasons to NOT take out a home equity loan:
The key thing to remember here is: if it’s frivolous or can put you in a worse financial situation, don’t do it. Simple, right?
“Home equity loans work best when they are used for purposes that strengthen your financial situation.”
Just about everything in life comes with a risk or two, and a home equity loan is no exception. Know the risks before taking the plunge.
Your home is on the chopping block
Remember, you are putting your home up as collateral. If you default on the loan agreement, you might have to bid your home adieu. This is what makes it different from other debt instruments like credit cards, where the worst thing that could happen is you get buried in fees and your credit score tanks.
Make sure you have the income to cover the payments or risk not having a place to lay your weary head at night.
Your home value may decrease
Sure, the Canadian housing market has been booming lately, but what happens if that bubble bursts? One possibility is that you become “upside-down” on your mortgage. Sounds painful, right? This happens when you owe more on your mortgage than the fair market value of your house. Quite a sticky situation, indeed.
Avoid this by preparing for the worst – or risk the chance of standing on your head for the foreseeable future.
Your credit score may fall
To many, their credit score is like their baby. They check on it (all too often) to make sure it’s safe and hasn’t fallen, do everything in their power to keep bad influences at bay and defend it to their grave.
The bad news is, that your beloved metric may be in danger when you take out a home equity loan. Since the lump sum you receive is so large, creditors see this as a risky move. After all, this is additional credit you are taking out. If you overextend your credit limits, you risk losing some valuable points.
Fortunately, there are various credit-building products out there. So, if you decide taking out a home equity loan is the right call us but are hesitant about its effects on your credit score — fret not! There are tools to build your credit history before you take out the loan to lessen its blow, or afterwards, to remediate your situation.
We all need fast money every now and again, and home equity loans can be an enticing “sleeping giant” to awaken when you need it most. After all, who doesn’t love the feel of a sack of cold hard cash in their hands?
But, as enticing as it may seem, there’s no such thing as free money – even if it is technically yours. So, be sure to examine all of the strings that are attached to a loan, or you might just find yourself on the outside, looking in.