All You Need to Know About Home Equity Loans
As you pay down your first mortgage or the value of your home increases, you develop equity. When you have equity built up in your home, borrowing against it with a home equity loan is a great way to tap into the money you need most. Many people take out a home equity loan to finance home improvements, pay for their child's college education, cover unforeseen medical costs, and many other purposes. Here's all you need to know about home equity loans.
What is a home equity loan?
A home equity loan (HEL), or second mortgage, is a secured loan that allows homeowners to borrow against the equity in their home. The loan amount is based on the difference between the home's current market value and the homeowner's outstanding mortgage balance. Home equity loans tend to be fixed-rate, while the typical alternative, home equity lines of credit (HELOCs), generally have variable rates and allow the borrower to withdraw funds as needed.
How is a home equity loan amount determined?
Your primary mortgage is the amount you borrowed when purchasing your home. Over time, as you pay down the loan and the value of your residence increases, so does your equity. You can take a home equity loan out against the equity you have built up in your home, essentially borrowing against your home's value minus what you still owe on your mortgage. It's important to note that a home equity loan is a second loan against your home. You'll still need to pay your primary mortgage and new home equity loan payments.
A lender typically wants you to have at least an 80 percent loan-to-value (LTV) ratio once your home equity loan has been approved.
Interest rates on home equity loans
Home equity loans typically have a fixed interest rate, making payment budgeting easy. The lender provides a lump sum payment to the borrower, which is then repaid over the life of the loan, along with a set interest rate. The monthly payment and interest rate will remain the same over the entire loan term, lasting anywhere from 5 to 30 years. The loan must be repaid in full if the borrower sells the home before the loan term is matured.
A home equity loan can be an excellent choice for a borrower with a one-time or straightforward cash need such as a home addition, significant medical expenses, debt consolidation, or a wedding.
Are there any costs associated with home equity loans?
As with mortgage loans, there are closing costs associated with home equity loans. Closing costs refer to any fees incurred when originating, writing, closing, or recording a loan. These fees include application, appraisal, title search, attorney fees, and points. Some lenders may advertise no-fee home equity loans, which require no cash at closing. Still, these will usually have other associated costs or a higher interest rate which can easily offset any gains.
What are the pros and cons of a home equity loan?
There are several advantages to taking out a home equity loan to fund a home improvement project or a significant expense:
The amount of interest paid toward a home equity loan may be tax-deductible.
Interest rates on HELs are generally lower than those provided by credit cards or unsecured loans.
Home equity loans do have some disadvantages as well:
Using your home as collateral for the loan means risking foreclosure and the loss of your home if you default on the loan.
If your home value declines over the loan term, you may owe more than your home is worth.
You'll need to pay closing costs and other fees when you take out a home equity loan.
You may qualify to borrow more than you need and ultimately end up using more than planned, which you'll need to repay.
The hot real estate market has led to a boom in the popularity of home equity loans. However, weighing all factors carefully before determining if a home equity loan is best for your specific needs is essential.