So you finally have your dream home (or you are hoping to buy it soon!). Although it would be great if you could throw down a giant pile of cash to make that big purchase, in reality that probably isn’t very feasible. So what do you do? You decide to get a mortgage. Although you may consider your mortgage as that wonderful financial resource that helped you purchase your new home, at the end of the day it is an actual debt you have incurred in order to get that great piece of real estate. Like most borrowed money, you are then responsible to repay that loan, plus any interest incurred on it.
There are a few different types of mortgages that are important to understand. Here’s a brief breakdown of each:
- Fixed Rate or “Traditional” Mortgage – the borrower pays the same interest rate for the life or the entire term of the loan. These are usually in 10, 15, 20 or 30-year increments. Luckily, in this case since it is a fixed interest rate, if the market interest rate rises, the borrower’s payment still remains the same. On the other hand, if the market interest rate suddenly drops, you also still pay the same rate, although the borrower may be able to take advantage of a refinancing opportunity to get a different rate.
- Adjustable-Rate Mortgage (ARM) – the borrower’s interest rate is fixed for a specified and agreed upon term, but then varies according to the market interest rates. A word of caution with this type of mortgage; often the initial interest rate is set below the market rate to entice the borrower in, but later it can fluctuate a lot depending on the market interest rates. Either way, the monthly payments are unpredictable after the initial term, so be sure to plan accordingly.
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Since your home is a huge investment and typically one of your most valuable assets, it can also be used to get a secondary loan that can be utilized for other large financing needs that come up. A home equity line of credit (also known as a HELOC) is a line of credit extended to a homeowner that uses the borrower’s home as collateral. It can be an advantageous option because a HELOC typically offers lower interest rates than other types of loans, and sometimes that interest can be tax deductible. Additionally, as you pay back your loan or if you still have funds available on it, then you can continue borrowing money (in other words, you aren’t shut off after receiving your initial installment). However, the downside is that you’re borrowing money against your home, so the lender can force you to sell your house if you become underwater or default on this secondary loan.
So here’s how it works: you can usually borrow up to 95% of the value of your home, less the amount you owe on your mortgage. Other factors that are considered in your HELOC rate include your income, outstanding debts, credit score and employment history (just like almost any other loan you would apply for). Once your maximum line of credit is set, the lender will determine your interest rate, which is usually set at a variable rate. It is initially set at the market rate, and then can go up or down depending on your credit history and financial health. As mentioned above, remember that variable interest rates are dependent on the market rate, so your payments can go up or down and can be unpredictable.
Sounds great, right? Although you always should be aware of your overall net worth and debt-to-income ratio, there are some specific scenarios when a HELOC may be a good option to consider:
- If You Need to Fix It – corrective maintenance and home repairs are necessary for a home to remain intact and working properly. Although usually not the most glamorous of purchases, it is important to monitor things like your air conditioning, water heater or plumbing. A Remodeling magazine article even states that you’ll recoup more of your investment in general maintenance, such as a new siding, a garage door replacement, or a roof repair, than on a major kitchen or bathroom remodel.
- If It Is Time for an Upgrade – with that said, you might be due for that upgrade you’ve been dreaming about for years. Upgrading can add value to your home in the long run. One of the most cost-efficient upgrades is a kitchen remodel. By upgrading appliances and revisiting your interior design, you can positively add to your overall return on investment.
- Time to Pay It Down – although it’s a popular practice to utilize a HELOC to put back into your home and increase its value, it can also be a good idea to use this secondary loan to pay off high interest debt. Whether that’s a credit card you’re getting hit with high interest rates or an auto loan that you’re treading water on, sometimes making a dent in this type of debt is exactly what you need to get it on the right track.
You’ve worked hard for that dream home, and you should be very proud. As you continue to build up equity in your house, it’s important to be aware that you have options and resources to use that big purchase as collateral for other investments. Whether a HELOC is the right option for your financing needs or not, doing your research and understanding all of your available options is key to maintaining your overall financial health and continuing to invest in your future.