As home values have risen over the past ten years, more homeowners experienced an increase in the amount of equity on their homes. This gives homeowners the flexibility of accessing that equity through products such as home equity loans and HELOCs. But are these products a good idea for you? Here are some factors that may help you decide whether or not you should take a home equity loan:
Definition of Home Equity Loan
A home equity loan is defined as the second mortgage through which a borrower can utilise the value of their homes. Home equity refers to the current valuation of the home you own, minus the balance on the current mortgage. Thus, if your home is appraised at $300,000 and you have a balance on your first mortgage of $180,000, you have $120,000 of equity. In home equity loan, one can borrow some percentage of this equity – usually up to 80 or 85 percent – in cash.
Home equity loans have fixed interest rates and fixed monthly payments, with terms ranging from 5 to 15 years. They operate as a conventional mortgage where the property in question – the home – is used as security on the loan.
Advantages of Home Equity Loans
This is the case because there are several potential benefits that can be derived from borrowing against home equity.
Get a large sum without credit checks - If one has a significant amount of equity in their home, a home equity loan can provide a large sum of money quite easily and without the need for credit checks.
Favorable interest rates – As compared to other forms of financing such as personal loans or credit cards, home equity loans have relatively lower interest rates. This can make them more affordable sources of funding for Small and Medium-sized Enterprises.
Tax benefits - The interest paid on home equity loan is tax deductive hence reduces the overall cost. Consult your tax professional.
Spending the funds – The money that is borrowed through home equity can be spent on anything such as home improvements, paying off credit card debts, investment in small business, and others. As for its usage, there are no restrictions as to their use like in the case of a first charge mortgage.
Drawbacks and Risks
Despite the above mentioned benefits of home equity loans, it should be noted that they entail several advantages and disadvantages which include
Closing costs – As with normal mortgages, home equity loans attract hefty closing costs such as application costs, appraisal costs and attorneys’ fees. The total of closing cost ranges from 2-5 percent of the total loan.
Risk losing home – In case the payments are hard to make at any one time, the home is at risk of being taken as security for the loans. Delays in payments can lead to the property being repossessed.
Affects other borrowing – They can reach other borrowing in a way that makes it difficult to qualify for future mortgages or refinancing.
Non-tax deductible – While mortgage interest is tax deductible, interest on home equity loans can only be claimed as a deduction if the borrowed amount was used to substantially improve the home. Any interest paid on the home equity for other uses is not allowed.
Interest can fluctuate – This is true with those who opt for adjustable-rate home equity loans since it means that they have to pay more as interest rates go up.
When doing the cost/benefit analysis, it is also important to think about how long you wish to live in the home. The longer the time horizon to repay the home equity loan, the more time is needed to recover the cost of closing and the higher chances of volatility in interest rates.
Some of the things that can help you get the best home equity loan include:
If a home equity loan makes sense for your financial planning, here is how you can find the best home equity loan.
Verify credit and income – Like any other form of funding, your credit score, your debts and your income will be reviewed when applying for a home equity loan. It is advisable to go for a credit score that is higher than 680.
Check the rates – Interest rates as well as the other fees that come with the closing may differ from one lender to the other; thus, do not hesitate to ask for quotes from the various lenders. In some cases, it is even advisable to borrow from online lenders as they can provide the lowest rates.
Know your fees – pay attention not only to the nominal interest rates but to the total cost of rates and fees. If closing costs are high, the savings in rate could be offset.
Require full disclosure – look at your quotes to ensure all your fees are itemized down to the penny so you know exactly what else you’ll have to pay at the time of closing. Avoid surprises.
Automated Payments – Paying your home equity loan on the go makes it possible to make the payments on time every month. This safeguards one’s home against possible foreclosure and aids in meeting requirements for future refinancing.
Measure the risk – Before going for a home equity loan, it is important to assess your personal financial position; job security, savings, and cash inflow among other factors to determine whether you wish to take more risk. It is important not to dismiss the risks or to overlook possible future financial consequences.
In conclusion, it can be ascertained that even though home values have ascended to new levels, enabling more equity to be accessed, it is still pertinent to consider the appropriateness of home equity loan proceeding. In essence, home equity loans can act as valuable financial tools for credit-restrained homeowners who require access to cash. However, for those who are merely interested in having money on the side or for impulse buying, the risks are likely to exceed the benefits. It is therefore wise to consider all the options before opting for the home equity route. Finally, for those proceeding with home equity loans it is crucial to shop for the best terms, understand all the costs involved, and plan correctly for payments. When employed correctly, these products should be viewed as a valuable part of one’s financial strategy. However, not being able to understand the associated risks is as good as turning home equity loans into problems that endanger homeownership.
