A home equity loan—also known as a “second mortgage”—can be an affordable way to borrow money against the equity you’ve built up in your home. Home equity loans allow homeowners to use their properties as collateral to secure large lump sums for a variety of reasons. This article will explain the ins and outs of home equity loans and important things to keep in mind as you decide whether a home equity loan or home equity line of credit is right for you.
What Is Equity?
To begin with, you need to understand what equity is. Essentially, it’s the difference in value between what you’ve paid towards your mortgage and what your home is worth.
You can build equity in two ways. First, pay down your mortgage. After several years of timely payments, you’ll begin to make a dent in the principal value of the loan. If your home is worth $250,000 and you only owe $200,000 on the mortgage, you’ve got $50,000 of equity in your home.
The second way to increase equity is by appreciation. If home values in your neighborhood go up, and your home is worth more than it was when you purchased it, your equity increases. In a second scenario, if you purchased your home for $250,000 and it’s now worth $300,000 thanks to new development, you’ve gained $50,000 in equity.
What Are Home Equity Loans?
Home equity loans allow you to borrow against the equity that you have in your home. A lender will use your home as collateral to secure the loan and provide you with a lump sum. You can use the loan proceeds to fund home renovation projects, your kid’s college tuition, or whatever you want. Thanks to the fact that your lender has security in your collateral, home equity loan rates tend to be more favorable.
Determining Your Home Equity
The first thing you need to do is figure out how much of your home you actually own. If your home is worth $250,000 and you’ve paid $50,000 towards your mortgage loan, then you have $50,000 in equity. You own, effectively, 20% of your house.
Equity is usually described in terms of a loan-to-value ratio. This ratio compares the portion that you owe to the total value of the property. For the $250,000 house on which you owe $200,000, that ratio would be 80%.
The second thing you can do to quickly assess the value of your home is to look at similar listings in your neighborhood. An appraiser will determine how much your home is worth when you apply, but this is a good way to get a basic idea of whether or not your property has appreciated significantly.
Keep in mind that lenders will not generally issue home equity loans for amounts less than $10,000. Most lenders won’t consider granting a home equity loan when you own less than 20% of your home, so you’ll need to build up a substantial amount of equity before you can apply. Also, note that lenders usually offer to loan a fraction of the total equity. If you have $100,000 in equity, for example, don’t expect to receive a loan offer for that amount.
Applying For A Home Equity Loan
Once you’ve got enough equity in your home to consider applying, the home equity loan approval process looks pretty similar to getting your first mortgage.
Your lender will pull your credit report and check your credit score, as this determines how much of a credit risk you are. The higher the score, the more likely your chance of approval and the better your interest rate should be. If a home equity loan is in your future, do what you can to improve your score before you apply.
You may also need to provide your deed, pay stubs, tax returns, etc.just as you did when securing your original home loan. Lenders want to verify that you can handle the monthly payment on your home equity loan in addition to your mortgage. They generally don’t want to see your total debt payments (including this and your mortgage payment) add up to more than 43% of your monthly income. Otherwise, it may be difficult to keep up with both payments.
Make sure that you look into different banks and lending institutions before you apply. There are many different products with different rates, terms, fees, and qualifications. Use a home equity loan calculator to see what you can expect. If you’re a good candidate for a home equity loan, your banking institution will probably offer preferential terms.
Benefits Of A Home Equity Loan
1. You’ll receive a large lump-sum payment. You can use the loan proceeds for any purpose, and you’ll have access to all of your loaned amount once you close.
2. If you decide to use your home equity loan to improve your property, like remodeling your kitchen, you may be able to deduct up to $100,000 of mortgage interest. Check with your tax adviser first.
3. Since your home secures your loan, interest rates on home equity loans may be lower than unsecured loan products, like personal loans or credit cards.
4. It may be easier for you to qualify for a home equity loan than other credit types since your house secures it.
5. Home equity loans are usually fixed-rate loan products so that you can budget for a consistent monthly payment.
Disadvantages Of A Home Equity Loan
1. Your home secures your home equity loan. This can be an issue if you default on the loan because the lender can foreclose to recoup its principal. If you sell the home, you have to pay the home equity loan back in full. Also, if your home loses value before you sell, you might wind up in a tight spot where you owe more than the house is worth.
2. Home equity loan rates may be higher than rates for a full mortgage.
3. Depending on the lender, you may be responsible for closing costs and fees that can add up pretty quickly.
Who Should Consider A Home Equity Loan?
You’ll benefit most from a home equity loan if you’re a responsible borrower with a consistent, reliable income. This type of loan can make sense to a lot of different people for a lot of different purposes.
Alternatives To A Home Equity Loan
Home equity loans are often used interchangeably with Home Equity Line of Credit (HELOC). Your home also secures a HELOC, but instead of the large lump-sum payment that you get when you close a home equity loan, you only draw down the line of credit as you need it, for as much as you need.
For example, suppose you have a $50,000 HELOC but only spend $20,000 for your planned kitchen remodel. You’ll only pay back the $20,000 that you borrowed.
A HELOC is a good option if you want to cover expenses that come up over time. These loans usually have adjustable rates, however, so you can’t count on a fixed monthly payment.
The other alternative to a straight home equity loan is a cash-out refinance. Here you’ll refinance your current mortgage into a new mortgage with a higher balance than you currently owe. At closing, you’ll receive the difference as a single payment.
With a cash-out refinance, you’ll get a single monthly payment. If your credit is in good shape, you might land a better interest rate than your original mortgage had. Because of lender fees and closing costs, though, this type of loan may be prohibitively expensive. As with any other type of loan, make sure you know what expenses you’ll have to cover or are rolled into the loan.
Home equity loans are a viable way to leverage the equity you’ve built up in your home. Because your house is held as collateral in such loans, interest rates are usually competitive.
If you have a steady, reliable income can handle the added expense of the home equity loans and need access to a large lump sum, a home equity loan may be right for you. You can use the loan proceeds to renovate your home (and you can deduct some interest payments on your taxes!) or pay off costlier types of debt.
Expect to go about securing your “second mortgage” much like you did your first. Sweep out your financial house before applying for a home equity loan. That way you’ll either continue to reap the rewards of fiscal responsibility, or you’ll start reaping them for the first time.
Since home equity loans offer lenders plenty of security, they’re obtainable and usually affordable. Keep in mind that your home is your collateral, though, and defaulting on second mortgage payments can lead to foreclosure.
If a home equity loan is right for you, know that A and N Mortgage is here to help you find the best option to help you accomplish your financial goals.
A and N Mortgage Services Inc, a mortgage banker in Chicago, IL provides you with high-quality home loan programs, including FHA home loans, tailored to fit your unique situation with some of the most competitive rates in the nation. Whether you are a first-time homebuyer, relocating to a new job, or buying an investment property, our expert team will help you use your new mortgage as a smart financial tool.