How to Use Home Equity and Its Risks

houses on top of coin stacks

If you’re a homeowner looking to buy an investment property, a low-cost and convenient way to fund the purchase is using your home equity. The house equity you have worked so hard to build can be leveraged to buy a second property to rent out for the sweet additional income or to be used as a vacation getaway without a cash deposit.

Accessing your home equity

One way of borrowing against your home equity is by cash-out refinance. With a cash-out refinance, you replace your existing home loan with a larger mortgage. You’ll have a new home loan, and a portion of your home equity will be accessible in a lump sum. However, in doing so, be mindful that you’re essentially borrowing more money, so the principal and interest repayments will be higher, and reimbursing the loan will take longer.

Another way of borrowing against your home equity is through Home equity loans or HELOC.

Home Equity Loans or HELOC

Home equity loans grant you access to a large fund, often at a reasonably low-interest rate, which makes them an enticing option in your toolkit for borrowing against your home equity. Comparatively, they are easier to qualify for as the loan is secured using your primary home as collateral.

With a fixed-rate home equity loan, also referred to as a second mortgage, you can get money as a lump sum and repay at a fixed interest rate over the duration of the loan. This could span to five years or as long as fifteen years or more. A fixed-rate home equity loan is a suitable alternative if you’re considering a big, one-time fund.

You can draw money as needed in a home equity line of credit (HELOC) and pay interest only on the amount you borrow. You’ll get an initial “draw phase,” much like a credit card, during which you can withdraw the amount you need (as long as your line of credit remains open). That’s why HELOCs are often a nifty option for expenses that can span over a long period, such as small-scale home repairs, college fees, etc. Small payments on your loan will suffice during the draw period, which lasts for a certain number of years. After the draw period expires, the repayment period begins, and you’ll have to pay off all of the debt more vigorously. HELOCs are usually subjected to variable interest rates, meaning you may have to pay much more than you expected.

Risks of Borrowing Against Your Home Equity

Like any financial decision, there are some major risks involved in borrowing against your home equity. Your house serves as the loan collateral. If you use home equity to buy an investment property and default on the repayments for any reason, then both your home and the investment property run the risk of foreclosure. Furthermore, using home equity to buy an investment property locks up your funds in an asset that is difficult and expensive to liquidate quickly in case of an emergency. Also, bear in mind that when buying a second property, you are not broadening your assets instead, you are further concentrating your resources. So you’ll also have to weigh in the risks of investing in real estate. Property values are not guaranteed to increase over time, and your home value will be subjected to real estate market fluctuations. When the market drops, the overleveraged homeowners are more likely to be underwater on multiple properties.

How to Qualify for Home Equity Loan

Equity is a homeowner’s asset. 80-90% of the value in your property can be released in equity to buy another property. You’ll need to fulfill certain criteria to obtain a home equity loan. The amount you owe on your mortgage must be lower than 80% of the property value. Your history of loan repayments must be sound. You must showcase your ability to pay back the loan to the lender. For which you’ll have to provide your last two payslips, the latest group certificate and documentation of your expenses and debts, and any other financial obligations. Your credit score is also indispensable when applying for home equity loans. A higher credit score will better your chances of qualifying for either type of loan.

Buying an investment property can be a superb way to build wealth. But before you engage in a new mortgage, there are things you can do to keep your financial health on the safe side. Evaluating your current financial circumstances, discussing with your family, having enough cash on hand for any rainy days, and investigating all costs and expenses are the ways you can mitigate the risks that come with borrowing against your home equity.

If you have any further doubts or want to discuss your financial situation and evaluate your potential, reach out to our experienced mortgage brokers at Capkon. Connect with Capkon to make better money decisions TODAY!

Author:

Kiran Thapa

Seema Lama

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