A Simple Guide To Understanding Home Equity Loans
Posted by Michael Favor III on
Getting a loan can be intimidating, especially if you’re not familiar with the financial industry. Suddenly, you’re confronted with dozens of terms you don’t normally use, like equity and fixed rates and collateral. Your head starts to swim and you may end up making decisions that can hurt you in the long run.
You need:
- A trusted explanation of the terms
- And understanding of the pros and cons of what you’re about to do
- help with making an informed decision
That’s what we’re here for!
Think of us as your loan tour guide.
In this post, we’re going to break down home equity loans. We’ll give you a simple explanation of each term, then help you understand exactly what a home equity loan means for you.
Ready? Let’s dive in.
What Exactly Is A Home Equity Loan?
Your home has a particular monetary value. For example, let’s say your home is worth $150,000 and you still owe $90,000 on your mortgage. The difference between what your home is worth and what you owe is called “equity”. So in this case, you have $60,000 in equity.
You can leverage the equity in your home to get a loan from a financial institution. The lender will see the amount of equity you have and can usually approve a loan up to that amount.
Since the loan is secured by this equity in your home, qualifying is easier than for a loan that is totally unsecured. Secured loans are less risky because the lender has more of a chance to recover the money they lend you.
If you’ve ever heard someone talk about a “second mortgage”, they’re referencing a home equity loan. Your first mortgage was the one with which you purchased your house. Your second mortgage is the loan secured by the equity in your home.
So far so good, right? Not too confusing.
Why Would You Want A Home Equity Loan?
Home equity loans have some advantages not available with other loans.
Because they’re secured by your home, you can usually get a lower interest rate. The lender knows they can recoup at least some of the funds if you default on your loan, so they’re willing to lend out money at a lower cost. The term may also be longer than other types of loans so you have a longer time period to pay off the loan. This also lowers your monthly payment.
There’s a better chance you’ll qualify for a home equity loan even if you have bad credit. Again, since you’re a homeowner and have equity in the property, the bank isn’t as concerned about not being able to recoup their funds.
Also, you may qualify for tax deductions with a home equity loan. This isn’t guaranteed and is obviously going to depend on your individual circumstances, but it is a possibility. Be sure to consult your tax advisor for qualifications and allowable limits.
Downsides Of A Home Equity Loan
A home equity loan is not all sunshine and roses. There are some downsides.
First and foremost, if you fail to pay your loan, the bank can seize your house and sell it to recover the money they lent you. After all, this is the heart of a home equity loan. Your house is the collateral. Granted, this is a worst case scenario, but it certainly needs to be on your radar. This can be a good thing though in the sense that it motivates you to keep with up with payments.
Also, it’s not a sure thing that you’ll get approved for your loan. Since the real estate crisis in 2007, lenders have to scrutinize home equity loans more carefully. They typically won’t let you borrow more than 80% of your home’s value (the “loan to value ratio”). It’s possible you might not qualify for the amount you hoped.
Kirk Haverkamp puts it this way:
Generally speaking, lenders are going to want you to have at least an 80% loan-to-value ratio remaining after the home-equity loan. That means you’ll need to own more than 20% of your home before you can even qualify. So if you have a $250,000 home, you’d need at least 30% equity—a loan balance of no more than $175,000—in order to qualify for a $25,000 home-equity loan or line of credit.
Additionally, it can be tempting to spend home equity funds on things that aren’t necessary or don’t raise the value of your home. Depending on the type of loan you get, your bank account may suddenly be flush with cash, tempting you to purchase a massive flat screen television or that car you’ve always been wanting.
Generally speaking, home equity loans should only be used on things that will improve the value of your home or life.
Motley Fool recommends using a home equity for only the following:
- Home improvements
- Emergency expenses
- Consolidating high interest debt
- Carefully funding investment properties
Also, because there’s a lot of value on the line (your home!), scammers tend to target those wanting home equity loans. Don’t ever get into a loan that either seems too good to be true or where the lender won’t put something down in writing. Review all documents very carefully and only do business with reputable institutions.
How Exactly Does A Home Equity Loan Work?
Generally speaking, there are two types of home equity loans.
- A lump sum disbursed all at once. This is what most people have in mind when they think of a home equity loan. Your interest rate is established in the beginning, you get the full balance at the start, and you repay the loan over time. Each repayment reduces the loan until you have a $0 balance.
- A home equity line of credit (HELOC). With a HELOC, you get approved for a maximum amount on a credit line and then only borrow what you need. You can borrow up to the limit of the loan and as you pay down the balance, you can borrow more if needed. It works the same was as a credit card.
Whether you choose a HELOC or lump sum depends on what you want. A HELOC is the most flexible, and you only pay interest on the amount you actually borrow. However, your interest rate may vary, which means that there’s the possibility it will go up.
If you need all the funds up front, you may want to choose a lump sum so that your interest rate will remain fixed and your money will always be available. If you only need some money but want more readily available, a HELOC is your best choice.
What Should You Do Before You Apply For A Home Equity Loan?
Before you apply for a loan, there are several steps you should take.
Step #1: Make sure you really want a home equity loan. Remember, with a home equity loan, you’re putting your house on the line. This is a big deal. Is a home equity loan better than a simple credit card or standard unsecured loan? Obviously, it’s going to depend on the amount you’re borrowing and what you plan to use it for.
Step #2: Gather your appropriate documents. Lenders want to see, at a minimum, proof of income and a house appraisal. They may handle the appraisal themselves or accept an appraisal you’ve had done within the previous 6 months. Talk to lenders and ask what they require before you apply.
Step #3: Manage your credit score. Before applying for a loan, check your credit score and make sure everything appears to be in order. If you have a really bad score, you may need to spend time improving it before you’re approved for a loan.
Step #4: Evaluate different lenders. There are a large number of options when it comes to getting a loan, including credit unions, banks, online lenders, mortgage brokers, and more. Evaluate their interest rates, repayment requirements, approval amounts, and the other facets of your loan.
Step #5: Map out your income and expenses. Your loan is going to add a significant expense to your monthly budget. Be sure that you’ve planned appropriately for repayment over the life of the loan.
Conclusion
See, that wasn’t so hard, was it? Now you have a relatively clear understanding of what’s involved in a home equity loan. You’re ready to go into the situation with confidence!
Will you be required to do a little research before getting your loan? Yes. You’ll need to determine which type of loan is best for you and the best place to get your loan. But that research will pay off in the end.
The research time you invest now will save you money and time in the long run.
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