When it becomes necessary to come up with a pile of cash, many homeowners see using their house as the easiest and most convenient way. Even those who have other assets can find this avenue appealing because they may not want to sell taxable holdings that will generate capital gains or pay withdrawal penalties on early IRA or retirement plan distributions. Those who borrow on their home equity have three options. The best one for you will depend upon your circumstances and objectives.
Secondary home loans are divided into three categories:
All three methods of accessing home equity have several characteristics in common. First and most important: Borrowers who don't repay these loans can lose their homes in foreclosure. The interest charged by each type of loan used to be deductible, but with the advent of the Tax Cuts and Jobs Bill, the criteria are different. The interest charged is deductible only if the loan is used to buy, build or substantially improve the taxpayer’s home that secures the loan. If used for those purposes, you can deduct interest on up to $750,000 of borrowing (note that this limit covers all real estate debt; it will be smaller if you also have a mortgage).
How much money you can borrow from your home's equity depends upon how much equity you have in your home. Equity is the difference between how much you owe and how much your home is worth. Lenders use this number to calculate your loan-to-value ratio, or LTV, a factor used to determine whether you qualify for a loan. To get your LTV, divide your current loan balance by the current appraised value.
Of course, the actual amount that is granted depends on your credit score and debt-to-income (DTI) ratio. A credit score of above 700 will probably qualify you for a loan. A little less than 700 may qualify you but with higher interest rates. The qualifying DTI varies from lender to lender, but most require that your monthly debts eat up less than 50% of your gross monthly income. Lenders add up the total monthly payments for your home, including – aside from your mortgage principal – interest, taxes, homeowner's insurance, homeowners' association dues and any other outstanding debt that is a legal liability. Then the debt total is divided by your gross monthly income – base salary, commissions and bonuses, as well as other income sources, such as rental income and alimony – to come up with the DTI ratio. Of course, it is always good to speak with a qualified credit counselor to help you decide whether or not you should apply for a loan.
The best form of tapping into your home equity probably depends more on what you will need the money for than anything else. Of course, your credit score and financial situation matter too, but they will be a factor regardless of which option you choose. In general, each of these methods are often matched up to the following situations and objectives.
Using your home as a source of funds can be a smart choice in some situations. Just be sure to carefully run the numbers and anticipate your future cash flow before signing on the dotted line. And, of course, this is only going to make sense if you have enough home equity to begin with. If you don't – or If you can get a better interest rate on a different kind of financing (say, a small business loan or a student loan) – take that option instead.
Home equity debt is not a good way to fund recreational expenses or routine monthly bills. But it can be a real lifesaver for those saddled with substantial, unexpected financial challenges – or who want to invest in their future. The key is making sure you are borrowing at the lowest rate possible and to use the funds for the intended purpose only.
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