Home Equity Loans

The Basics of Home Equity Loans

PIGGY BANK HOUSE
Your home stores value, and you can tap into that value (if it makes sense). Todd Davidson PTY LTD. / Getty Images

Home equity loans allow you to borrow against the value stored in your home. They can be useful for borrowing large amounts of money, and they’re easier to qualify for than other types of loans because they are secured by your house.

If your home is worth more than you owe on it, a home equity loan can provide funds for anything you want (you don’t just have to use it on home-related expenses, for example).

A home equity loan is a type of second mortgage. Your “first” mortgage is the one you used to purchase your home, but you can use additional loans to borrow against the property if you have built up enough equity.

Benefits of Home Equity Loans

Home equity loans are attractive to both borrowers and lenders. Here are a few of the key benefits for borrowers:

  • Low rates: Home equity loans typically have a lower interest rate than unsecured loans (usually quoted as APR), which can help keep borrowing costs low.
  • Approval: They are (somewhat) easier to qualify for if you have bad credit.
  • Potential tax benefits: Interest costs on a home equity loan may be tax deductible, but not everybody qualifies for that benefit.
  • Large amounts: Borrowers can qualify for relatively large loans with this type of loan, assuming you have significant equity in the home.

Safe for lenders: Most the benefits above (except for the tax deduction) are available because home equity loans are generally safe loans for banks to make: the loan is "secured" with your house as collateral.

If you fail to repay, the bank can take your property, sell it, and recover any unpaid funds (this process is known as foreclosure). What's more, borrowers tend to prioritize these loans over other loans because they don’t want to lose their homes (faced with the choice of missing a mortgage payment or a credit card payment, you might skip the card payment).

Approval is not guaranteed: Banks have to be careful not to lend too much, or they risk significant losses. Before 2007, it was extremely easy to get approved. Since the housing crisis, things have changed, and lenders will actually evaluate your application. To protect themselves, they try to make sure that you don’t borrow any more than 80% or so of your home’s value – taking into account your original purchase mortgage as well as any home equity loan you’re applying for. The percentage of your home's value available is called the loan to value ratio, and may vary from bank to bank.

Home equity loans are only approved if you can demonstrate that you have the ability to repay. Lenders are required to verify your finances, and you'll need to provide proof.

How a Home Equity Loan Works

When you borrow with a home equity loan, you can use one of two options:

  1. Lump-sum: Take a large sum of cash and repay the loan over time with fixed monthly payments. Your interest rate can be set up-front, and each monthly payment reduces your loan balance and covers some of your interest costs (it is an amortizing loan).
  2. Line of credit: Get approved for a maximum amount available, and only borrow what you need. Known as a home equity line of credit (HELOC), this option allows you to borrow multiple times, and make smaller payments for several years until you have to start making fully amortizing payments to eliminate the loan.

    The HELOC is the most flexible option, as you only pay interest only on the amount that you actually draw out of your pool of available money. Interest rates on HELOCs are generally variable, so your interest costs can change (for better or worse) over time. However, your lender can freeze or cancel your line of credit before you’ve had a chance to use money that you need (possibly just before you were planning to use the money), so that flexibility comes with some risk.

    To get a loan, you’ll apply with a lender, and it’s wise to shop among several different sources. Interest rates may vary from place to place, and you’ll have to pay closing costs to get your loan funded.

    Lenders will check your credit, require an appraisal, and take several weeks (or more) to release any money. Treat the process as if you were applying for a home purchase loan: get your pay stubs and other documents organized to make it go faster.

    Repayment depends on the type of loan you get. With a lump-sum loan, you’ll typically make fixed monthly payments (the same amount every month) until the loan is paid off. With a line of credit, you may be able to make small payments for several years during your “draw period” (which might last ten years or so). After the draw period ends, you’ll need to make regular payments to pay off the debt. However, you can generally pay off either type of loan early to save money.

    Common Home Equity Loan Uses

    You can use a home equity loan for anything you want. However, they usually get used for some of life’s larger expenses because homes tend to have a lot of value to borrow against. For example, you find that a lot of borrowers want to:

    • Remodel, renovate, or otherwise improve the house and property
    • Pay for a family member’s college education
    • Fund the purchase of a second home
    • Consolidate high-interest debts

    Pitfalls of Home Equity Loans

    Before using a home equity loan for any purpose, you should be aware of the risks of using these loans. The main problem is that you can lose your home if you fail to meet the payment schedule required by the lender.

    Because these loans can provide a lot of cash, it's tempting to use your home as an ATM. Be sure to use your home's equity only for things that will improve the value of your home, add significant value to your life (this does not include “wants” or luxuries), or lead to a higher income for your family. This is a case where it’s particularly important to evaluate “good” debt and “bad” debt.

    Another common pitfall of home equity loans is that scammers have found plenty of ways to cheat homeowners out of their most valuable asset (or at least get a lot of cash out of the deal). Be sure that you know who you’re doing business with. If something smells fishy (like a high-pressure sales pitch or a reluctance to put things in writing), then take a step back and make sure you’re not dealing with a con artist.

    How to Find the Best Home Equity Loans

    Finding the best home equity loan can save you thousands of dollars – or more. To get the best loan:

    • Shop around. Try a variety of sources (credit unions, banks, mortgage brokers, and online lenders).
    • Manage your credit score and make sure your credit reports are accurate.
    • Ask your network of friends and family who they recommend.
    • Compare your offers to those found on websites and advertisements.

    Additional Tips

    Before you borrow, pause and make sure that this type of loan makes sense. Is a home equity loan a better fit for your needs than a simple credit card account or an unsecured loan? If you’re not sure, figure it out before you put your home at risk.

    Also, make a detailed plan of your income and expenses (including this new loan payment) ahead of time. These large loans can come with large payments.

    Review and consider insurance (life and disability) to cover the payments if something happens. You may or may not need insurance, and nobody can force you to use it. If you decide to include insurance as part of a home equity loan, go with monthly premium payments – not an up-front option – so that you only pay for what you use (assuming the insurance is just for the home equity loan).