Home equity.

Suggestions on how to borrow on home equity.

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As you pay your mortgage down and the value of your home increases, you build up home equity. This is the difference between the value of your home and the remaining balance.

You can use home equity to borrow money for other things such as home improvement projects, paying off high-interest credit cards and loans, funding college tuition, and even just taking a much needed vacation – basically whatever you want – at low interest rates.

Lower interest rates are available because the loan is secured with your home equity; if you’re unable to make your loan payments, then your home can be sold by the lender to recover the debt. Although that’s a risk you may not want to take, your home equity greatly lowers the lender’s risk and therefore interest rates are much lower than for unsecured loans.

There are a few ways that you can borrow on your home equity.

1) Refinancing: By refinancing, you are accessing some of the home equity you built up. Normally, you can borrow up to 80% of the appraised value of your home, minus the amount of your mortgage you have left to pay off. Suppose that you need some extra money for home renovations. Your home is currently worth $250,000 and you have $150,000 to pay off. The maximum amount available for renovations through refinancing would be ($250,000 x  80%) – $150,000 = $50,000. If you borrow this amount, then your mortgage balance would be $200,000.

Refinancing may trigger changes to the terms of your mortgage agreement, and the refinanced portion may have a slightly higher interest rate.  Also, there may be administrative fees, such as the appraisal fee, title search or title insurance, and legal fees.  If your lender allows you to borrow more than 80% of your home’s appraised value, then you also have to pay mortgage default insurance premiums, which drive the borrowing costs up.

2) Borrowing back prepaid amounts: If you’ve made lump-sum payments on your mortgage, then your lender may allow you to re-borrow some of this money.  The amount you re-borrow is added to your mortgage balance and may have a different interest rate.

3) Home equity lines of credit (HELOCs): Unlike the first two options, which provide lump sums, a HELOC allows you to borrow money when you want it up to a credit limit. You can pay the money back and re-borrow it as needed.

Guidelines issued by the Office of the Superintendent of Financial Institutions (OSFI) state that federally regulated lenders such as banks should limit new HELOCs to 65% of the home’s appraised value. Combined with your regular mortgage, you can borrow up to 80% of your home’s value.  So if your home is worth $250,000 and you have $150,000 left to pay off, then the maximum credit limit on your HELOC would be the minimum of [$250,000 x 65% = $162,500] and [($250,000 x  80%) – $150,000 = $50,000], i.e., $50,000.

HELOCs may have similar administrative fees to refinancing, as well as fees for transactions, inactivity, and maintenance.

4) Second mortgages: If you take out a mortgage with a different lender that is secured on a home that has already been mortgaged, then this is known as a second mortgage.  Here you have to make regular payments on two mortgages: the original mortgage and the second mortgage. There may also be administrative fees involved.

If you can’t make your mortgage payments, then the original mortgage holder gets first dibs on proceeds from the sale of your home used to pay off your debt. Because giving you a loan is riskier for the second lender, the second mortgage will usually have higher interest rates.

The maximum amount you can borrow through a second mortgage is usually 90% of your home’s appraised value, minus your outstanding balance on the first mortgage. If the total amount you owe to both lenders is greater than 80% of your home’s value, then you need to pay mortgage default insurance premiums.

Using either of these methods to borrow on home equity can be a very cost effective way of accessing much needed cash for unexpected expenses. It can also allow you to get your finances under control by consolidating debts from credit cards and other high-interest loans.