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Buying a Home: Understanding Home Equity

Provided by Visa, Content Partner for the SME Toolkit

One of the biggest advantages of home ownership is the equity you build in your home. The faster you pay your mortgage and build this equity, the better financial shape you'll be in. Equity can be a powerful tool to manage your finances.

Paying Off Your Mortgage
During the first few years you make payments on your mortgage, most of your payment goes toward interest and not very much goes toward paying down the principal. The more you owe on the mortgage, the more interest you'll pay. So if you increase the amount you pay, more of the principal will be paid and less interest will be charged. You could retire your mortgage several years ahead of schedule if you just make one extra mortgage payment per year.

Home Equity Credit Lines
A home equity line of credit is a form of revolving credit in which your home serves as collateral. With a home equity line, you will be approved for a specific amount of credit that represents the maximum amount you can borrow. You pay a variable interest rate and have a minimum payment due each month based on the amount of the credit line you have used.

Once approved for the home equity plan, you will be able to borrow up to your credit limit at any time. You can draw on your line of credit by writing checks against it. You may be charged for a property appraisal, application fee and possibly other costs.

When you sell your home, you will be required to pay off your home equity line in full. If you are likely to sell your house in the near future, consider whether it makes sense to pay the up-front costs of setting up an equity credit line. Also keep in mind that leasing your home may be prohibited under the terms of your home equity agreement.

Home Equity Loans
Similar to a home equity line of credit, a home equity loan is backed by your home as collateral. Because they are considered more secure by lenders than unsecured debt such as credit cards, home equity loans offer more attractive interest rates than unsecured loans.

A home equity loan is best utilized for a specific expense, such as paying college expenses, which you will be able to pay off over a shorter time period than your primary mortgage. If you're carrying a great amount of high-interest, unsecured debt, transferring it to a home equity loan can help you pay it off sooner, as well as provide tax advantages.

Just remember that you've used your home as collateral. If you can't keep up with the payments, you may lose your home.

If interest rates have dropped since you took out your mortgage, you may want to consider refinancing your home - that is, getting a new mortgage with a better interest rate to replace the old one. As a general rule, if you can cut your rate by 2% or more, it is worth investigating. Depending on how much the new bank charges in closing costs and how long you plan to stay in your home, you could end up saving a significant amount of money this way.

You do not have to refinance with the same mortgage broker that you originally used. It's wise to try them first, as they may offer you an attractive package in order to keep your business, but shop around and compare rates as you did the first time around.

Costs versus Benefits
To make sure you're going to save money by refinancing, take all the costs into consideration.

  • Closing Costs Remember these? You will have to pay them again when you refinance. Depending on how high they are, they may overshadow the savings you will get from your new interest rate and it may not be worth it to refinance.
  • Pre-payment Penalties Your current mortgage may have a significant penalty for pre-payment that could overshadow the savings that result from refinancing. Check your mortgage papers. If a pre-payment penalty exists, it will be in your agreement.

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