For most homeowners, home equity is their most valuable asset. It represents the portion of your property that you’ve paid off. For instance, if your home is valued at $250,000, and your mortgage balance is $150,000, your home equity is $100,000.
A home equity loan – also known as a second mortgage – allows you to potentially borrow against your home equity. Home equity loans provide a relatively easy way to gain access to large amounts of money. They’re easier to qualify for because you’re using your home as collateral.
In this article, we explore all you need to know about home equity loans.
How Do Home Equity Loans Work?
There are two variants of home equity loans: foxed rate loans and revolving line of credit.
- Fixed-rate loans
When most people use the term ‘home equity loan’, they’re often referring to a fixed-rate loan. Fixed-rate loans provide you with a single lump sum, which can be used to cater for a major renovation, unexpected medical emergency, or any other huge financial issue. This debt is typically secured by your property.
A home equity loan must be repaid at an agreed-upon interest rate over a set period, usually five to 15 years. This means you start monthly repayments after you secure the loan. Since a home equity loan comes with a fixed interest rest over the lifetime of the loan, you know exactly how much you’re going to pay back.
- Home Equity Lines of Credit (HELOCs)
A home equity line of credit (HELOC) is a variable-rate loan that works just like a credit card. When you secure a HELOC, you’re granted a maximum amount from which you can make withdrawals. You can then make withdrawals as frequently as you like until you exhaust your credit. The initial withdrawal period usually lasts up to 10 years, after which you must begin making repayments. Repayment periods tend to be from 10 to 20 years.
Because of the flexibility of HELOCs, most of them come with variable interest rates. This means that your monthly payment can go up or down over the loan’s lifetime. It is possible to get HELOCs at fixed interest rates, but the interest rate tends to be higher.
Pros of Using Home Equity
Here are some of the pros of home equity loans:
- Easy access to a large sum
A home equity loan can provide you with easy access to a large sum of money. If this amount is used to finance a home improvement – for example, a kitchen remodeling – then you can potentially increase the value of your home.
- Lower interest rate
Home equity loans are secure because they are backed against your home equity. Hence, home equity loans have lower interest rates than unsecured debts like personal loans and credit cards. A lower interest rate significantly reduces the cost of the loan. It also makes it easier to pay off the debt faster by making more than the required minimum payments.
- Tax Benefits
Before the Tax Cuts and Jobs Act of 2017, home equity loans were entirely deductible. Homeowners could borrow up to $100,000 and still deduct all of the interest when they filed their tax returns.
However, the new law limits what qualifies for deductions. Homeowners are allowed to deduct the mortgage interest if the money is used for capital improvement, such as to “buy, build, or substantially improve” the home that secured the loan.
Cons of Home Equity
Common drawbacks of home equity include:
- Borrowing Costs
Some lenders charge fees for home equity loans or HELOCs. While shopping for a home equity loan, make sure you pay attention to the annual percentage rate (APR), including the interest rate plus other fees. The last thing you want is a high APR.
- Risk of Foreclosure
Because your home is used as collateral, you risk losing it if you fail to make payment. Similarly, if your home value drops, you can end up owing far more than your current home value. This means you won’t be able to sell your home without taking a major loss.
- Misuse of funds
As we’ve identified, home equity loans are relatively easier to obtain. That’s why you have to use them wisely. Most people use them for renovations, pay for college, start a business, or consolidate high interest. You have to identify the risks inherent in what you want to do to determine if it’s worth it. Furthermore, it’s prudent to stick to your needs to avoid living beyond your means.
Requirements to Qualify for a Home Equity Loan
If you’ve determined that a home equity loan makes sense for you, here are some of the minimum requirements needed to secure one.
- A credit score of 620 or higher. Having a score higher than 700 will enable you to obtain the loan at the best rates.
- You must have at least 20 percent equity in your home.
- Your debt-to-income ratio must be lower than 43 percent.
- You must demonstrate your ability to repay your loan.
- Home equity loans are long-term loans. So while you take out one, get ready to make repayments for up to 30 years.
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