Home Equity Loan
Table of Contents
Understanding Home Equity Loans: A Comprehensive Guide
Home equity loans have become an increasingly popular financial tool for homeowners looking to leverage the equity in their homes. This article delves into what home equity loans are, how they work, their benefits, risks, and considerations for those contemplating this financial option.
What Is Equity?
To begin with, you need to understand what equity is. Essentially, it’s the difference in value between what you’ve paid towards your mortgage and what your home is worth.
You can build equity in two ways. First, pay down your mortgage. After several years of timely payments, you’ll begin to make a dent in the principal value of the loan. If your home is worth $250,000 and you only owe $200,000 on the mortgage, you’ve got $50,000 of equity in your home.
The second way to increase equity is by appreciation. If home values in your neighborhood go up, and your home is worth more than it was when you purchased it, your equity increases. In a second scenario, if you purchased your home for $250,000 and it’s now worth $300,000 thanks to new development, you’ve gained $50,000 in equity.
What is a Home Equity Loan?
A home equity loan, often referred to as a second mortgage, allows homeowners to borrow money by using the equity in their home as collateral. Equity is the difference between the home’s current market value and the outstanding mortgage balance. Home equity loans provide a lump sum of money, which is then repaid over a set period with fixed monthly payments.
A home equity loan, also known as a second mortgage, lets homeowners borrow money by drawing on the equity value in their homes. Home equity loans exploded in popularity in the late 1980s, as they provided a way to somewhat circumvent the Tax Reform Act of 1986, which eliminated deductions for the interest on most consumer purchases. With a home equity loan, homeowners could deduct all of the interest when filing their tax returns.
A HELOC is a revolving line of credit, much like a credit card, that you can draw on as needed, pay back, and then draw on again, for a term determined by the lender. The draw period (five to 10 years) is followed by a repayment period when draws are no longer allowed (10 to 20 years). HELOCs typically have a variable interest rate, but some lenders offer HELOC fixed-rate options.
A home equity loan—also known as a “second mortgage”—can be an affordable way to borrow money against the equity you’ve built up in your home. Home equity loans allow homeowners to use their properties as collateral to secure large lump sums for a variety of reasons. This article will explain the ins and outs of home equity loans and important things to keep in mind as you decide whether a home equity loan or home equity line of credit is right for you.
A lender will use your home as collateral to secure the loan and provide you with a lump sum. You can use the loan proceeds to fund home renovation projects, your kid’s college tuition, or whatever you want. Thanks to the fact that your lender has security in your collateral, home equity loan rates tend to be more favorable.
How Do Home Equity Loans Work?
Home equity loans come in two varieties: Fixed-rate loans and revolving lines of credit. With both types of credit, you’re borrowing money based on a percentage of the appraised value of your home minus any outstanding mortgage debt. Typically, you may be able to borrow up to 80% of the home’s value, assuming there’s no first mortgage loan.
Your home is used as collateral for the loan. As a result, if you don’t repay the loan or line of credit, the mortgage lender can foreclose, meaning the bank takes possession of the home and sells it to recoup the loan proceeds.
Home equity loans operate similarly to primary mortgages. Here’s a step-by-step breakdown:
- Determine Equity: Calculate your home equity by subtracting the outstanding mortgage balance from the current market value of your home.
- Loan Application: Apply for a home equity loan through a bank or financial institution. The lender will assess your creditworthiness, income, and the value of your home.
- Loan Approval: If approved, the lender will offer a loan amount based on a percentage of your home’s equity, typically up to 85%.
- Receiving Funds: Once approved, you receive the loan amount in a lump sum.
- Repayment: Repay the loan over a fixed term, usually 5-30 years, with fixed monthly payments.
| Average Home Equity Interest Rates | ||
|---|---|---|
| Loan Type | Average Rate | Range |
| 15-year fixed | 5.82% | 2.99%–9.03% |
| 10-year fixed | 5.60% | 2.99%–9.99% |
| 5-year fixed | 5.28% | 2.50%–9.99% |
| HELOC | 5.61% | 3.50%–8.63% |
HELOCs Vs Home Equity Loans Explained | The Pros and Cons
Advantages and Disadvantages of a Home Equity Loan
There are a number of key benefits to home equity loans, including cost, but there are also drawbacks.
Advantages
Home equity loans provide an easy source of cash and can be valuable tools for responsible borrowers. If you have a steady, reliable source of income and know that you will be able to repay the loan, then low-interest rates and possible tax deductions make home equity loans a sensible choice.
Obtaining a home equity loan is quite simple for many consumers because it is a secured debt. The lender runs a credit check and orders an appraisal of your home to determine your creditworthiness and the CLTV.
The interest rate on a home equity loan—although higher than that of a first mortgage—is much lower than that of credit cards and other consumer loans. That helps explain why a primary reason that consumers borrow against the value of their homes via a fixed-rate home equity loan is to pay off credit card balances.
Home equity loans are generally a good choice if you know exactly how much you need to borrow and for what. You’re guaranteed a certain amount, which you receive in full at closing. “Home equity loans are generally preferred for larger, more expensive goals such as remodeling, paying for higher education, or even debt consolidation because the funds are received in one lump sum,” says Richard Airey, senior loan officer with Integrity Mortgage LLC in Portland, Maine.
Disadvantages
The main problem with home equity loans is that they can seem an all-too-easy solution for a borrower who may have fallen into a perpetual cycle of spending, borrowing, spending, and sinking deeper into debt. Unfortunately, this scenario is so common that lenders have a term for it: reloading, which is basically the habit of taking out a loan to pay off existing debt and free up additional credit, which the borrower then uses to make additional purchases.
Reloading leads to a spiraling cycle of debt that often convinces borrowers to turn to home equity loans offering an amount worth 125% of the equity in the borrower’s house. This type of loan often comes with higher fees: Because the borrower has taken out more money than the house is worth, the loan is not fully secured by collateral. Also, know that the interest paid on the portion of the loan that is above the value of the home is never tax deductible.
When applying for a home equity loan, there can be some temptation to borrow more than you immediately need because you only get the payout once and don’t know if you’ll qualify for another loan in the future.
If you are contemplating a loan worth more than your home, it might be time for a reality check. Were you unable to live within your means when you owed only 100% of the equity in your home? If so, then it likely will be unrealistic to expect to be better off when you increase your debt by 25%, plus interest and fees. This could become a slippery slope to bankruptcy and foreclosure.
How to Calculate Your Home Equity
Equity is the difference between what a home is worth and what’s owed on a mortgage loan.
To calculate your home equity, first get an estimate of your home’s value by researching the value of homes like yours in your neighborhood that have recently sold. Say that figure is $350,000. And assume the balance of your loan, which you can get from your mortgage lender, is $150,000. With those figures, here’s how to calculate your home equity:
Equity = Value of home – loan balance
Equity = $350,000 – $150,000
Equity = $200,000
Example of Home Equity
If you buy a home for $300,000 with a 20% down payment (covering the remaining $240,000 with a mortgage), you’ll have equity of $60,000 in the house.
If the house’s market value remains constant over the next two years, and $15,000 of mortgage payments are applied to the principal, you would have $75,000 in home equity at the end of the two years.
If the home’s market value had also increased by $100,000 over those two years, you would then have $175,000 in home equity.
Risks of home equity loans
There are two main types of loans that use your home as collateral:
home equity loans and home equity lines of credit (HELOCs). Here are their risks.
Your home is on the line
The stakes are higher when you use your home as collateral for a loan. Unlike defaulting on a credit card — whose penalties amount to late fees and a lower credit score — defaulting on a home equity loan or HELOC could allow your lender to foreclose on your home.
Before taking out a home equity loan, make sure you understand all the terms and conditions. Compare your household income to your monthly expenses to see if you can really afford the payments.
Home values can change
With elevated mortgage rates and high home prices constantly in the news, the idea of a drop in property values seems hard to imagine nowadays. Yet it can happen, and even has in a few overheated real estate markets around the country.
When you tap into your home equity, you’re essentially reducing your ownership stake in your home. This can be a real problem if property values fall, as you might end up with very little equity or even owe more than your home is worth — a situation known as negative equity.
Interest rates can rise with some loans
While loan terms vary by lender and product, HELOCs generally have adjustable rates, which means that payments increase as interest rates rise.
“The interest rate on a home equity line of credit is often tied to the prime rate, which will move up if there’s inflation or if the Fed raises rates to cool down an overheating economy,” says Matt Hackett, chief operating officer at mortgage lender Equity Now.
Home equity loans, on the other hand, typically have fixed interest rates, so you’ll know exactly how much your monthly payment will be for the entire loan term.
Payments could skyrocket
While you can usually pay back whatever you borrow at any time, many HELOCs allow interest-only payments during their draw period (when you actually access the funds). Tempting as that is, if you only make these minimum payments, you won’t make any progress in paying down your outstanding balance.
Your credit score can drop
Opening a home equity loan can also affect your credit score. Your credit score is made up of several factors, including how much of your available credit you’re using.
Depending on your financial situation, a large home equity loan to your credit report can negatively impact your credit score by increasing the amount of available credit you’ve utilized.
In the long run, having a home equity loan and making regular monthly payments can strengthen your credit by showing you can handle long-term debt responsibly. Just be aware of the short-term drop you’ll likely see.
Your debt load will increase
Any loan increases your debt burden and the demands on your income, of course. But by tapping into your home’s equity, you’re essentially depleting your ownership stake — transforming a valuable asset into a costly obligation.
How to Use Home Equity
You can use your home equity and the funds you borrow to your financial benefit.
- Eliminate PMI: Cancel your private mortgage insurance when your equity reaches 20%. Usually, PMI is automatically canceled once your equity reaches 22%. However, you can request its removal at 20%.
- Consolidate debt: You can use a home equity loan or line of credit backed by equity to pay off credit card balances that carry high interest rates. Rates on home equity borrowing are usually much lower.
- Fund expenses: Use home equity loan funds to fund major purchases instead of using credit cards. That way, you can minimize higher-cost debt. For example, use the funds to pay for college tuition or a wedding instead of taking out a loan.
Considerations Before Taking a Home Equity Loan
- Financial Stability: Assess your financial stability and ensure you can handle the additional monthly payments.
- Purpose of the Loan: Use the loan for meaningful investments like home improvements, education, or debt consolidation rather than discretionary spending.
- Interest Rates: Compare interest rates from various lenders to get the best deal.
- Alternative Options: Consider other financing options such as personal loans, cash-out refinancing, or lines of credit.
- Loan Terms: Understand the loan terms, including the repayment period, interest rates, and any potential penalties for early repayment.
When Is A Home Equity Loan The Right Choice?
Home equity loans can be a great loan option for some homeowners. Here are a few situations in which a home equity loan makes the most sense:
- If you need money fast: A home equity loan is a good choice when you need a large amount of money immediately but want to lock in a lower interest rate than you’d find with a credit card or personal loan.
- If you have a strict, fixed budget: Home equity loans can be the right option when you have one specific expense and are aware of the full amount that you’ll need to spend on it.
- If you’re paying off higher-interest debt: They’re also the better choice if you want to use the funds to pay off other debts that have higher interest rates, as you’ll know your rate won’t change.
Conclusion
Home equity loans can be a valuable financial resource for homeowners who need access to funds. However, they come with significant risks and responsibilities. Before opting for a home equity loan, it’s crucial to carefully evaluate your financial situation, the purpose of the loan, and alternative financing options. By making an informed decision, homeowners can effectively use home equity loans to meet their financial goals while safeguarding their home investment.
In conclusion, home equity loans can be an excellent option for homeowners looking to tap into the equity they’ve built up in their property. These loans offer a variety of benefits, including lower interest rates and more flexible terms than traditional loans.
However, it’s essential to consider the risks and responsibilities that come with a home equity loan, including the potential for foreclosure if you default on the loan.
Shopping around and comparing different options is essential to find the best deal for your needs. Ultimately, a home equity loan can be a powerful financial tool, but it’s necessary to use it responsibly and clearly understand the potential risks and rewards.
Frequently Asked Questions About Home Equity Loans
- What are the downsides of a home equity loan?
- Is it a good idea to take equity out of your house?
- Can I take equity out of my house without refinancing?
- What happens if you can’t pay back a home equity loan?
- What are the advantages of a home equity loan?
- What are the risks of a home equity loan?
- How do I qualify for a home equity loan?
- What is the difference between a home equity loan and a HELOC?
- How are interest rates determined for home equity loans?
- Can I get a home equity loan with bad credit?
- Are there any fees associated with a home equity loan?
- How long does it take to get a home equity loan?
- Can I use a home equity loan for investment purposes?
- What are the repayment terms for a home equity loan?
