A home equity loan is a kind of loan that is availed by those who own a home and they use the home as security when borrowing money. Home equity is computed as the current market value of the home less any remaining loan balance. Therefore if the home is valued at $300,000 and you have a mortgage of $180,000, then the homeowner has $120,000 in home equity. However, with a home equity loan, you can access the equity in your home and receive a large sum of money.
An overview of how Home Equity Loans operates
To obtain a home equity loan, you approach a lender such as a bank or a credit union. The lender will then have to assess the value of the home to understand the market value and the amount of money you can borrow. The lender will extend an offer to lend you up to a certain percentage of your available equity, this is normally at 75-85% of your home’s value. Thus, if you have $120,000 in equity, in the example above, you could be eligible for a home equity loan of up to $90,000.
The amount from the home equity loan proceeds would then be deposited directly to your bank account in one lump sum for any purpose such as home repairs, paying off credit card debt, college tuition fees, hospital bills, etc. Like a mortgage, you would repay the loan in equal monthly installments for a certain term, usually 5 to 30 years. The home equity loan gets fixed to the title deed of the house so in case you failed to pay the loan and the balance became due, the lender can force you to sell the house in an attempt to recover the loan amount using the security.
However, one important characteristic of home equity loans is that the interest rates are generally very low because the loans are secured by your home. Interest for home equity loans is about 5% with higher interests compared to credit cards or personal loans. But, it is to be noted that these loans also involve closing costs and fees, which can range between 3-6% of the loan amount. There is also the possibility of your home being seized and sold to recover the money if you fail to pay.
Advantages of Home Equity Loans
There are several potential benefits that make home equity loans appealing financing options for homeowners:There are several potential benefits that make home equity loans appealing financing options for homeowners:
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Cash flow – A home equity loan gives you an amount of cash that can be used to pay for large expenses, pay back high interest bearing loans, avoid selling of investments, etc. If you require thousands of dollars to make payments, a home equity loan is one means of accessing equity you have already created in your home.
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Flexible repayment – Home equity loans are relatively cheaper to service, as the interest rates accorded range between 4-6% at the moment. This payback method helps qualify the loan faster and it also means that more of your monthly payments go to principal reduction.
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Amortization schedule: Home equity loan payments are made on a regular monthly basis, which means that budgeting for such a loan is not a struggle over the years as you pay for the money that was borrowed.
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Long-term – You can usually decide how long you want the payment period to be that is, 10 years, 20 years or in some cases, 30 years. This makes monthly payments lower. But, longer terms do mean you pay more interest.
- Tax-deductible (often) – The interest on home equity loan is tax-deductible if you use the loan for home improvement purposes, which is beneficial to you. Consult an accountant to discuss who is eligible and what the cutoffs are.
Risks To Understand
While home equity loans have their benefits, there are also some notable risks to consider:While home equity loans have their benefits, there are also some notable risks to consider:
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You can lose your home - If you fail to pay the agreed installments, then you are in default and the lender can sell your house and recover the money. You lose the shares that you might have had in the property.
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Closing costs and fees – It is common to pay between 3% and 6% of the total loan amount. It reduces how much of the usable cash that one actually gets.
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Risks with rates – Fixed rates are given when taking home equity loans and in the future if rates drop significantly then you cannot benefit. You also cannot refinance later without being subjected to other fees and costs.
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Reduced future borrowing capacity – Whenever you access equity, the amount that is available to you for financing is lowered if other contingencies arise in future.
- Difficult to compare – Determining which home equity loans to apply for from which lender can be a challenge due to differences in interest rates, loan limits, terms, and fees. It is important to get good advice.
Alternatives To Consider
Depending on your specific situation and needs, here are a few alternatives to consider rather than getting a home equity loan:Depending on your specific situation and needs, here are a few alternatives to consider rather than getting a home equity loan:
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HELOC – Home Equity Line of Credit is similar to credit cards but is associated with equity. It is more preferable to have a line of credit where you can get cash as and when you need it rather than receiving a single amount. Often enter with lower initial investment or capital outlay.
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Cash-out mortgage refinance – You borrow more than the balance amount that is owed, the extra amount is paid to you and the new, bigger mortgage is taken. That is why, based on fees as I mentioned, rates are very low in 2022 and it may make sense.
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Personal loan – An unsecured personal loan is usually more expensive but has regular repayments and no home on the line. May be beneficial if you require a lesser amount (not exceeding $35000).
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Using savings – This means that instead of borrowing and incurring interest charges, it is better to use savings even if this means cutting on other investments.
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Home downsizing - To some, it could help access equity as a chance to sell a bigger, costlier home and get the cash.
- Retirement accounts – A very poor option to consider, but early withdrawals from 401ks and IRAs can provide the money if managed correctly. This does come with risks such as penalties and other tax concerns.
Speak to professional financial consultants and beneavorers to get a full understanding of the choices and the possible downsides in which you may find that a home equity loan is suitable best for you or whether there exists a more suitable product in the market for you. However, if applied carefully and returned on time, home equity can offer plenty of options and advantages that are hard to come by with other products.
