The popularity of home equity loans, also known as second mortgages, is once again on the rise, after greatly diminishing during and right after the recession. If you are in the process of comparing loan options, here is information you need in order to determine if you could qualify for a home equity loan, and if it would work well with your financial situation.
The first thing you need to know is that in order to qualify, you need equity, which is the portion of your home that you own yourself compared with the portion that is still owned by the bank through your mortgage. The amount of equity you have when looking at a loan like this is frequently described as a loan-to-value ratio. This ratio is calculated by comparing the balance that you still need to pay back to the bank to the total value of the property.
“Generally speaking, lenders are going to want you to have at least an 80 percent loan-to-value ratio remaining after the home equity loan,” according to a credit.com report on the Buying Home section of Fox Business. “That means you’ll need to own more than 20 percent of your home before you can even qualify. So if you have a $250,000 home, you’d need at least 30 percent 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.”
You should also know that there are two general types of home equity loans. Standard home equity loans are the first main type, and with this type, you will borrow funds in one lump sum. A home equity line of credit, otherwise known as a HELOC, is the other main type. With a HELOC, you will be given a set maximum amount that you can borrow against, and then you will be authorized to borrow smaller increments of money as you need them, but never exceeding that limit. They have variable rates and a set term, at which point you must pay back any outstanding debt.
Standard home equity loans are typically sought after by people who are facing one big expense, such as making a home repair or addition. These loans can be obtained on either a fixed or an adjustable interest rate, but most borrowers seek those with fixed rates. The fixed interest rate is higher than the rate on the first mortgage, but it is lower than the interest paid on credit card debt and many other types of loans. This is why many people obtain home equity loans to pay off credit card debt.
Funds from a home equity loan are repaid over a set length of time, which can go up to 30 years. You have to pay closing costs on these loans, but they are not nearly as expensive as the closing costs of a full mortgage. The interest you pay is tax-deductible, so if borrowers use them to pay off other debt (known as debt consolidation), they end up with a single payment that is easy to track, has a lower interest rate and conveys tax benefits.
Borrowers may be more attracted to a HELOC if they have large expenses in their future but those expenses are variable in nature, such as with a home renovation project that stretches over many months. They are also popular for people who have recurring large expenses like tuition. With the HELOC, you can access variable amounts of money over time as your needs change by using a special checkbook or credit card.
If you are using a HELOC or a home equity loan to pay for home improvements, which is one of the most popular reasons to borrow against home equity, make sure to consider the value of your project carefully. Not all home improvement projects are created equal, so there is no guarantee that you will gain enough home value to balance the burden of taking out the loan.
“While remodeling the kitchen or bathroom generally adds value to a house, improvements such as a swimming pool may be worth more in the eyes of the homeowner than of the market determining the resale value,” according to Investopedia. “If you’re going into debt to make cosmetic changes to your house, try to determine whether the changes add enough value to cover their costs.”
No matter what reason you have for obtaining funding against the equity of your home, you need to make sure you are fully able to pay it back in the allotted time. Also, if you are using it to cover other debt, such as credit card debt, make sure you are not getting into an endless cycle by using the newly freed-up balance on the credit card to make unnecessary purchases that you will later have to cover with further loans.
“If the borrower defaults, the lender gets to keep all the money earned on the initial mortgage and all the money earned on the home-equity loan; plus the lender gets to repossess the property, sell it again and restart the cycle with the next borrower,” cautions Investopedia.
If you think carefully about the terms of your loan, the way you will use the funds, and your ability to pay it back, you will be able to make an informed decision that can benefit your financial future. While home equity loans do have substantial risks, they can also have great benefits for certain borrowers. Talking to your financial institution can help you determine the exact nature of your situation.