What's a Home Equity Loan?
To begin, equity is the dollar amount that you own in your home. For example, say you purchased a house 10 years ago for $250,000. Since then, you’ve paid the loan down by $100,000, leaving the balance at $150,000. If you listed your house on the market today, it would get an appraisal of $300,000. You’d then deduct the balance owed by the new appraisal amount, which would give you $150,000 in equity.
However, when it comes to a home equity loan, lenders will only approve the loan-to-value ratio, which is the balance you own on the house as opposed to the new appraised value. That means you could secure a loan for $100,000, not $150,000. Since the amount of equity continues to grow as people pay their mortgages, it’s common for them to wait to secure a home equity loan until the loan-to-value ratio makes it worthwhile.
Don’t confuse a home equity loan with a home loan
since these are two different things. When you decide to purchase a house, you’d need to secure a mortgage loan. In exchange for the payments you make each month, you have the privilege of living in the home while building equity at the same time. As mentioned, a home equity loan is the value of equity you have in your residence.
Advantages of a Home Equity Loan
With a home equity loan, commonly known as a second mortgage, you continue paying on the first mortgage along with an additional payment for the second one. Following are some of the benefits that go hand-in-hand with a loan of type.
- Interest – typically, lenders offer fixed interest, which means if the rate increases at some point in the future, your payments would remain the same. For budgeting purposes, this helps tremendously. Something else worth noting is that since you use your house as collateral, the rate of interest is usually lower than what you’d pay on a personal loan or even on credit cards for that matter
- Payout – another advantage of a home equity loan is that you receive the money borrowed in one lump sum. For that reason, you can easily pay off outstanding debt or start a home improvement project. With this type of loan, you can use the money any way you want, including taking a lavish vacation or honeymoon, sending your kids to college, and so on. In other words, there aren’t restrictions as to how you use the funds
- Qualifying – since the money goes against what you already own in the form of equity, qualifying is relatively easy. Unlike your first mortgage where you had to have excellent credit, there’s a little more leeway for the lender to approve a home equity loan
Disadvantages of a Home Equity Loan
Along with some incredible benefits of a home equity loan are a few potential drawbacks to consider.
- Collateral – with a home equity loan, you put your house up for collateral. Therefore, if you ever find yourself facing financial hardship, there’s a risk of losing it. In fact, if you default on the loan, the lender could start the foreclosure process, something you want to avoid at all costs
- Additional Expenses – the other factor is that, like your first mortgage loan, you’ll have to pay closing costs and related fees. Keep in mind that some lenders allow borrowers to roll these expenses into the loan, which eliminates the need for you to pay money out of pocket. However, because they’re still a part of the loan, you pay interest on them
Paying for a Home Equity Loan
Although you borrow money against the equity in your home, you still have a monthly payment due to the lender. Therefore, it’s essential that you first determine if you can afford to add another expense to your monthly budget. If you can, you’d make the payment based on the options the lender offers, whether via mail, electronic funds transfer or automatic deposit.
Tips for Deciding if a Home Equity Loan is Right for You
With so many benefits, some people take out a home equity loan without giving much thought as to whether it makes sense. In addition to confirming that you can afford an additional payment, you should consider the following to help you make the right decision.
- Credit score– although it’s easier to qualify and the interest rate is lower for a home equity line compared to other types of loans, you still want to have excellent credit. Based on your FICO score, the lender will determine the interest you pay and the terms offered. When you have a high credit score, you can expect the lowest interest and the best terms available
- Tax laws – the government recently approved a new tax law for home equity loans. Under the change, the only way you can take a tax deduction is if you use the money for home improvements to the property associated with the loan. If that’s the case, you’ll qualify for a tax deduction in the full amount of the loan if it doesn’t exceed $750,000
- Risk – it’s vital to stress that if you miss payments or default on the loan, you could face losing your home. Therefore, make sure you’re in a good financial position so you avoid any possible risk
As you can see, there are plenty of reasons to consider a home equity loan. However, you have another option in the way of a home equity line of credit or HELOC. While somewhat similar, the primary difference is that instead of receiving a lump sum, the lender allows you to take a draw against the money borrowed.
For instance, if you borrowed $100,000 against the equity in your house but chose a HELOC instead of a conventional home equity loan, you’d have that much money available to pull from. If you decide to renovate your residence, you’ll make payments toward the various projects as the experts complete them.
That means if the plumber charges you $10,000, you’ll draw the required amount from the line of credit and once he completes the job to your satisfaction, you should draw the remaining amount due. This type of loan also has many advantages, making it a viable option.
Once you determine that a home equity loan is right for you, the next step entails finding a reputable lender. For this, you might start by talking to your bank or credit union, but you could also check out options through credible online sources. When you want to borrow money, and if you have equity in your property, a home equity loan provides a sound opportunity.