Securing a loan with your home equity is one of the easiest ways to get low interest rates. If you need a lot of cash, it’s a great way to use your most valuable asset (your property) to secure a loan.
While tapping into your home equity may seem attractive, you need to be careful. Home prices are higher in Canada than ever before and rising quickly, which makes home equity more plentiful. But if you aren’t careful, it’s your property that’s on the line after all. There are a few things you need to keep in mind if you want to use this powerful tool.
What You Need To Tap Into Your Equity
Using your home equity is fairly easy. But you will need to meet a few minimum requirements before you’re able to.
First, you’ll need to have sufficient equity available. Most lenders will need you to have enough to justify a loan. A good rule of thumb is to only consider tapping into your home equity if you have at least 20% in your home.
Lenders will have their own minimum credit score requirements. If your credit score is in the mid-600s or higher, you will have many opportunities for loans with lower rates. But having a lower credit score won’t necessarily hold you back. Lower credit scores will usually just mean higher APRs for your loans.
Lenders want to see a reliable source of income for their borrowers. But they also want to make sure you’re not already struggling with debt. So, they’ll have a look at your debt-to-income ratio. If your debt-to-income ratio is lower than 40%, it shouldn’t stop you from tapping into your equity.
To be safe, it’s best to not take on significant amounts of debt. Unless you’re consolidating debt, if your debt-to-income ratio is already high, you might want to think twice.
Have A Good Reason
The best safety tip for tapping into your equity is to make sure it pays off. There are several ways you can ensure you’re getting an excellent deal. Frivolous spending with borrowed money is unsafe in many circumstances, not to mention pointless from a purely financial point of view. The goal is to produce a net gain for yourself.
Consolidating Credit Card Debt
Consolidating higher-interest debt is arguably the best reason to tap into your equity. Credit cards can easily set you up for a rough time if you don’t pay your balance at the end of the month. Credit card interest rates are notoriously high, with most at 19%. Some credit cards go as high as 29.99%.
You can use your equity to secure a debt consolidation loan. You would then use the loan to immediately pay off all your credit card balances. The result is you have one large debt to pay off instead of many smaller ones. But your interest rate on a home equity loan will usually be far lower than the rate on your credit card. That means you can save a lot of money and save your credit score at the same time.
Using your equity to secure a home improvement loan is another move that just makes sense. When you make improvements to your home, you add value to it. That’s why tapping into your equity to allow you to sell your house for a much higher price just makes sense!
If your current equity allows for it, you can add a basement or another addon to your property. With the value this creates for your home, you could sell it for more.
There is one way to tap into your home equity that stands out for its retirement benefits. A reverse mortgage can help you afford retirement through a repayment-deferred loan.
If you’re simply short on cash for retirement, a HELOC is likely your better choice.
If you or someone close wants to advance their education, tapping into home equity is one way to do it. Like some of our other examples, education expenses are an investment for which you can get a great return. Because some equity loans, especially HELOCs, are so inexpensive, they are good options for paying education expenses.
Place Safe Limits
Regardless of what you want to spend your money on, there is always a financial line you cannot reasonably cross. That’s why if you’re not borrowing money to reduce your debt, you can’t afford to borrow too much.
One factor to be aware of is the loan’s APR. An APR can be sneaky because it’s not quite the same as an interest rate. For example, a $10,000 loan with a 5% APR and a 5-year repayment term will mean a monthly repayment of $188.71, but a total of $1,605.48 in interest payments. But what if the repayment term is just 2 years? It would cost you $443.43 per month and you would pay $642.26 in interest.
To make sure you don’t overburden yourself. Do the math on any loans you are considering taking. Fortunately, there are plenty of online APR calculators that can determine your monthly repayments and the total amount you’ll pay in interest.
What Is A Safe Loan?
Safe is a subjective term. But there’s a reason many lenders will cut you off with a debt-to-income ratio higher than 43%.
If you’re already overburdened with debt, it’s risky to take on more debt. So, ask yourself what you will get out of your equity. Tapping into your equity can help you reduce debt if you approach it safely.