Home equity loans allow homeowners to dip into the equity they have built to help pay for life’s expenses. Often referred to as a second mortgage, these loans are secured by your property if you fail to make your monthly payments.
When used strategically, home equity loans can help you reach your financial goals and may offer interest or tax savings.
What is home equity?
Home equity is the difference between how much you still owe on your mortgage loan and the current value of your house.
But the value of equity in your home can change over time. For instance, let’s say you made a 5% down payment of $10,000 on a $200,000 home and took out a mortgage loan to cover the remaining $190,000.
When you purchased your home, your home equity would equal the initial down payment of $10,000, or 5% equity. Gradually, the amount of your home that you own increases as you continue to make your monthly mortgage payments—assuming the value of your home doesn’t change. Eventually, you will have 100% equity in your home once your mortgage is fully paid off.
You can tap into your home’s value to help finance large expenses like home renovations or consolidating debt if you have at least 15 to 20% home equity. One way to do this is by taking out a home equity loan.
How home equity loans work
A home equity loan is secured by the value of equity you hold in your home. In other words, if you fail to repay your loan, you face the risk of the bank foreclosing on your home. Because of this, lenders thoroughly review your credit history, income, and debt-to-income ratio before qualifying you for a home equity loan to ensure you have a high chance of repaying your debt.
Once you qualify for a loan, the funds are typically dispersed in as little as two weeks as a lump-sum payment with a fixed repayment period of up to 30 years. Your monthly payment includes both the principal balance of the loan and any additional interest, which is usually stated as a fixed-rate.
How much can you borrow using a home equity loan?
The exact amount you qualify for depends on guidelines set forth by your lender, including your combined loan-to-value ratio (CLTV). This ratio calculates the difference between the current value of your home and the amount you intend to borrow. “Most lenders will typically allow a homeowner to get a line of credit of up to 80–90% of the current value of their home,” says Shmuel Shayowitz, president and chief lending officer of Approved Funding, a privately held mortgage bank in River Edge, NJ.
Let’s say you have $200,000 in home equity, you may qualify for up to a $170,000 home equity loan—assuming you meet any additional credit, income, or employment requirements assessed by your lender.
How to make the most of your home equity loan
The funds borrowed from a home equity loan can help cover a wide variety of expenses, including home repairs or college expenses.
Because home equity loans typically offer a lower fixed-rate APR than credit cards or other unsecured loans, consolidating debt that is racking up variable interest may save you money in the long run.
To put this into perspective, let’s say you owe $5,000 on a retail credit card that charges an APR of 25%. With a minimum monthly payment of $160, it would take 52 months to pay off your balance in full and cost an additional $3,169.55 in interest.
But, if you transferred this $5,000 balance to a home equity loan charging an APR of 8% with the same $160 monthly payment, it would take just 36 months to pay off and reduce your total interest to $625.50.
Using a home equity loan to foot the bill of a costly home improvement project can actually increase your home’s value. Whether you plan to maximize the value of your home to resell or turn your current house into your dream home, updating your home can yield a significant return on your investment.
Not only can it improve the value of your home, but certain projects such as building an addition to your current home may offer tax breaks on the interest paid on your home equity loan.
Unfortunately, emergencies happen. In a pinch, you can use a home equity loan to help cover unexpected expenses such as medical bills because they offer a lump sum payment with a fixed interest rate and monthly payment.
It’s important to note that other emergencies, like sudden loss of a job, may not be the best use of funds from a home equity loan because there is no guarantee you will be able to repay the funds owed. This puts you at an increased risk of losing your home if you are unable to find work.
“Most people have good intentions about using home equity loan funds for short-term expenses and plan to repay them as soon as possible, but often this is not the case, unfortunately,” says Shayowitz.
One of the largest risks involved with obtaining a home equity loan is the possibility of losing your home—but there are other factors to consider when deciding if a home equity loan is right for you, such as additional fees or credit implications.
The biggest downfall of home equity loans is that the funds borrowed are backed by your home, meaning there is a chance you’ll lose your home if you can’t repay your debt.
“Unlike personal loans or credit cards, HELOCs are recorded liens against a homeowner’s property which could lead to a foreclosure if the loan goes into default,” says Shayowitz.
While this is the worst-case scenario, it is important to consider when determining what loan amount, term length, and interest rate you are comfortable taking on. Generally, it’s a good idea only to borrow the amount you need.
Home equity loans are often referred to as second mortgages, and may have a similar fee structure to the one you paid on your initial mortgage. Depending on your lender, you may be required to pay origination fees or closing costs on the loan. Because home equity loan amounts are limited to a percentage of the value in your home, your lender may also require you to obtain an appraisal before approval.
You may receive special rates on your home equity loan or a closing cost discount through your local bank or credit union. Consider shopping around multiple lenders to ensure you receive the best rate and quote available.
Impact on credit
Applying for any type of loan or credit card triggers a hard inquiry on your credit report, which results in a temporary reduction of your credit score. These inquiry types usually remain on your credit report for two years, according to Experian.
After being approved for your loan, making your regular on-time payments can boost your credit score. Conversely, failing to make your payments can negatively impact your score.
Using the equity you have built in your home can help you achieve financial goals, like paying off debt or renovating your home with a favorable interest rate on your loan and potential tax benefits. But if misused, home equity loans may have detrimental effects on your finances.
Home equity loans are secured by your home, so you face the risk of foreclosure if you fail to meet your repayment obligations. Consider taking out only the funds you need to reduce the amount of your required payments, which can potentially save you money on interest while still helping you reach your financial objectives.
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