How To Use Your Home Finance Equity To Eliminate Debt
Doug Smith

Defined Tag: Finance Equity.

The finance equity in your home is the amount of your home's original purchase price for which you have already paid. This equity is not the same as the amount of the loan you have already paid. The loan consists of principal (the original purchase price) plus interest (the cost of borrowing money). Financially, the loan total will be higher than the purchase price because of the interest you pay.

In a very simple example, assume you want to buy a house that costs $100,000. You then finance that loan by obtaining a $100,000 mortgage at a given interest rate. Each monthly payment you make to the lender consists of two parts: principal plus interest. The cumulative amount of the principal that you pay is called the equity. When your principal payments equal $40,000, then you own 40% of the home. The financed equity in the home has reached $40,000 at that point.

How does this help with your debt? Once you have sufficient equity in your home, you can finance a Home Equity Loan (HEL) or a Home Equity Line of Credit (HELOC). These loans used to be called second mortgages, but generally have better interest rates and repayment terms than a strict second mortgage. These loans are relatively easy to get and often have lower interest rates. This is because your house is used as collateral to secure the loan. If you cannot repay the loan, the bank or credit union can simply repossess your house and sell it to recover its money.

The Home Equity Loan is a lump sum you receive at the closing (which is ironically the beginning of the loan period). The maximum amount you can borrow is typically 100% of your current equity, which is $40,000 in the above example. Some states limit the equity to 80% of the current value. Others allow over-equity loans in which lenders will finance you for more than your home's equity.

A Home Equity Line of Credit is different than a HEL. You do not receive a lump sum at the closing. Instead, you are given a maximum amount of money that you can borrow, which in the above example is $40,000. If you need $15,000 to finance a car loan, you can borrow that sum against your line of credit. You will be required to repay that $15,000 plus interest.

The HELOC consists of two distinct time periods. The first is the draw period, lasting about 5 to 25 years. During this time, you can borrow up to the maximum amount ($40,000), and repay those amounts plus interest. At the end of the draw period is the payback period, in which you will either repay any outstanding amount in a lump sum, or by a given payback schedule.

Once you have financed a low-interest loan based on your home's equity, you can use that money to pay off high-interest debts. The debt burden is not eliminated, but you are exchanging expensive high-interest debt for more economical low-interest debt. That is why borrowing against the finance equity in your dwelling can be a smart way to reduce debt.

Copyright 2008 by Doug Smith. All Rights Reserved Worldwide. Unauthorized Duplication Prohibited. Not Intended As Professional Advice.