Home equity can be a powerful tool in a person’s financial arsenal as they move to advance their stage of life and improve their financial position. In Canada, home equity debt is quickly rising to become one of the most common sources of debt in the country. While this particular line of credit can help advance a person or family into a new and better stage of life, it can also cause problems if handled improperly or without the right knowledge.
Having a basic understanding of what home equity is, and how/when it can work for you is essential before you even consider taking a loan against your home. Read on to get a crash-course on home equity and home equity loans (curtesy of a friend who’s a mortgage broker in North York).
What is Home Equity?
To put it simply, home equity is the portion of the home that you truly own-the portion that has been paid off. As property values increase or the mortgage on the property becomes closer and closer to paid in full, the amount of equity a person has on their home increases. To figure out how much equity you have on your home, a simple calculation is in order:
The property’s market value – outstanding loan balances = home equity value
Home equity is a part of your total net worth, and you can do what you want with it. Many people pass their home equity onto their children or other heirs, while some take money out from their equity to buy a new home, pay for retirement or tackle unexpected financial obligations.
How do I Build Home Equity?
There are two ways to build the equity of your home: paying back your mortgage loan, and the price appreciation of the house.
Price appreciation is something that is entirely out of the homeowner’s control, meaning that they can increase their home equity without even trying! When the property gains value, home equity increases all on its own.
Paying back your mortgage loan is an essential part of home ownership, as well as building home equity. The more of the loan that you have paid off, the more the house really “belongs” to you.
What are Home Equity Loans?
Home equity loans are very easy to obtain when compared to other forms of loans that you might qualify for. It makes a large sum of money available to you at relatively low interest rates, so you might be tempted to reach for it when a sudden expense comes up or you need to make some big renovations around the house.
It is also called a “second mortgage” when you borrow money against the value of your house. You will not only be responsible for paying the remaining balance of your existing mortgage, but you will also have to pay back the amount borrowed against its equity as well.
There are two types of home equity loans:
- Lump-sum home equity loans, wherein the homeowner gets a one-time, large-sum payment. This typically comes with a fixed-rate interest.
- Home Equity Lines of Credit (HELOC), which allows the homeowner to withdraw funds as needed. HELOC loans come with variable-rate interest.
What are the Downsides of Home Equity Loans?
Taking a loan against the value of your home can be a tremendous step in the right direction, particularly if your financial situation doesn’t change in any significant way. However, a loan of this nature isn’t without its risks. As per the terms of a home equity loan, the home itself is used as a form of collateral. This means that the bank can take the home and then sell it to get their money back if you default on your loan repayments.
The possibility of losing one’s home in this case is reason enough to be especially wary when considering home equity loans. When large life expenses rear their heads and have you considering borrowing against the value of your home, be cautious. These loans are incredibly tempting, but carry with them a significant risk that could leave you or your family without a home.