What Is a Home Equity Loan?
A home equity loan is a fixed-rate second mortgage secured by your ownership interest (equity) in the home. It provides a fixed quantity of funds, thus it is ideal for borrowers who know precisely how much money they require.
Due to the fact that your property serves as security for the loan, home equity lenders often charge lower interest rates than for personal loans and credit cards. Like with other loans, however, the interest rate you receive on a home equity loan will vary based on your lender, credit score, income, and other criteria.
How a Home Equity Loan Works?
A home equity loan is essentially the same to a mortgage, hence the term “second mortgage.” The home’s equity acts as collateral for the lender. The maximum amount a homeowner can borrow will be determined in part by a combined loan-to-value (CLTV) ratio between 80% and 90% of the home’s appraised value. Obviously, the loan amount and interest rate charged rely on the borrower’s credit score and payment history.
Conventional home equity loans, like conventional mortgages, have a fixed repayment period. The borrower makes consistent, fixed principle and interest payments. Similar to any other mortgage, if the loan is not repaid, the home could be sold to cover the remaining balance.
If you decide to move, you may lose money on the sale of your house or be unable to relocate. And if you’re taking out the loan to pay off credit card debt, fight the urge to rack up your credit card expenses again. Before putting your home in peril, you should consider all of your choices.
After the Tax Reform Act of 1986, home equity loans soared in popularity because they allowed consumers to circumvent one of its key provisions: the abolition of interest deductions for most consumer purchases. The act preserved one significant exception: interest on the servicing of home-based debt.
As with a mortgage, you can request a good faith estimate, but before you do so, you should create your own honest financial estimate. Casey Fleming, branch manager at Fairway Independent Mortgage Corp. and author of The Loan Guide: How to Obtain the Best Possible Mortgage, advises, “To save money, you should have a thorough
understanding of your credit score and home’s value before applying.” “Particularly on the appraisal, which is a significant investment. If your assessment is too low to sustain the loan, the funds have already been spent, and there are no reimbursements for failing to qualify.
Before signing—especially if you’re using the home equity loan for debt consolidation—verify with your bank that the loan’s monthly payments would be lower than the sum of your present payments. Although while home equity loans offer lower interest rates, the new loan could have a longer term than your previous indebtedness.
Home Equity Loans vs. HELOCs
Home equity loans give the borrower with a lump-sum payment that is repaid over a predetermined length of time (usually five to fifteen years) and at an agreed-upon interest rate. For the life of the loan, both the payment and interest rate stay unchanged. The loan must be repaid in full upon the sale of the property on which it is based.
A HELOC is a revolving line of credit, similar to a credit card, that you can use as needed, repay, and then use again for a lender-determined duration. The draw term (five to ten years) is followed by a repayment period during which no further draws are permitted (10 to 20 years). Most HELOCs have variable interest rates, although some lenders provide fixed-rate HELOCs.
Advantages and Disadvantages of a Home Equity Loan
Home equity loans are a convenient source of cash and can be useful tools for dependable borrowers. If you have a stable source of income and are confident that you will be able to repay the loan, home equity loans are a wise choice due to their low interest rates and potential tax benefits.
As a secured debt, obtaining a home equity loan is quite simple for many individuals. To evaluate your creditworthiness and the CLTV, the lender does a credit check and orders an appraisal of your home.
Although greater than that of a first mortgage, the interest rate on a home equity loan is significantly lower than that of credit cards and other consumer loans. This helps explain why one of the top reasons individuals obtain a home equity loan with a fixed interest rate is to pay off credit card balances.
If you know exactly how much you need to borrow and for what purpose, home equity loans are a fantastic option. You receive the guaranteed amount in full upon closing. According to Richard Airey, senior loan officer with Integrity Mortgage LLC in Portland, Maine, “home equity loans are generally selected for larger, more expensive purposes like as remodeling, paying for higher education, and even debt consolidation”
The primary disadvantage of home equity loans is that they can appear to be an all-too-simple answer for borrowers who have slipped into a cycle of spending, borrowing, spending, and increasing debt. Regrettably, this situation is so widespread that lenders have a phrase for it: reloading. This is the practice of obtaining a loan to pay off existing debt and free up new credit, which the borrower then utilizes to make added purchases.
Reloading leads to a debt spiral that typically motivates borrowers to obtain home equity loans for an amount equal to 125% of the equity in their property. Typically, this sort of borrowing carries higher fees: The loan is not fully secured by collateral because the borrower has borrowed more than the value of the property. Moreover, note that interest paid on the part of the loan that exceeds the home’s value is never tax deductible.
Home Equity Loan Requirements
Each lender has its own requirements, however most applicants will typically need the following to qualify for a home equity loan:
- Equity in their property exceeding 20% of the value of their home
- Verifiable income history spanning at least two years
- A credit score in excess of 600
Typical Rates on Home Equity Loans
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The rates assume a $25,000 loan amount and an 80% loan-to-value ratio. The interest rate on a home equity line of credit (HELOC) is based on the rate at the time of the credit line’s inception; thereafter, rates are subject to vary based on market conditions.
Illustration of a Home Equity Loan:
Consider an auto loan with a $10,000 amount, a 9% interest rate, and two years remaining on the term. Consolidating this debt into a home equity loan with a 4% interest rate and a five-year duration would cost you extra if you took the full term to repay the home equity loan. Remember that your home now serves as security for the loan instead of your automobile. If you default on your mortgage, you risk losing your home, which would be far more devastating than losing your vehicle.