What is a Home Equity Loan?
A home equity loan is a type of loan that you can take out using your house as collateral. If you've paid off a lot of your mortgage, you may be able to get a loan based on the value of your home. Home equity is the difference between how much your home is worth on the market and how much you still owe on your mortgage.
A home equity loan is paid out as a large combined sum of money with a fixed interest rate. When you take a home equity loan, you are expected to pay back the loan in fixed monthly installments that are pre-agreed with the home equity lender. A home equity loan's repayment period starts soon after the loan is given out and can last anywhere from 5 to 30 years, depending on the loan terms.
A home equity line of credit sometimes referred to as a HELOC, is also a type of loan that can be taken using your house as collateral. However, it works much like a credit card, with the loan amount varying as per your needs and with variable interest rates. The repayment of a HELOC is divided into two phases:
1st Phase: The draw period
You are allowed to borrow as needed on the credit amount allocated, making only minimum payments and maybe interest-only payments on the borrowed amount. Reaching your limit during this period will force you to pay off some of the borrowed amount before being allowed to borrow again. The length of the draw period varies greatly among lenders but typically lies between 10 and 15 years.
2nd Phase: The repayment period
At the end of the draw period comes the repayment period, where you can no longer access the HELOC funds. During this time, you have to pay back all of the HELOC funds you took out during the draw period. This includes both the principal and the interest.
Since your home is used as collateral, home equity loans and home equity lines of credit have lower interest rates and better terms. Before deciding on a home equity loan or a HELOC, it's a good idea to look around for the lender with the lowest fees.
How to Qualify for a Home Equity Loan
Different home equity loan lenders have different eligibility requirements. However, the general requirements to qualify for a home equity loan are:
Sizeable amount of equity in your home
You need to have paid a large share of your mortgage to qualify for a home equity loan. Typically, home equity loan lenders require you to have 15% to 20% equity in your home to qualify for a home equity loan. Home equity is obtained as a percentage by dividing your mortgage balance by the appraised value of the home.
Excellent credit score
A credit score ranging from the mid-600s and above will more likely get you approved for a home equity loan. However, a credit score of 700 or above is ideal and presents a higher chance of approval. Certain lenders tend to vary the terms of the home equity loan depending on the credit score of a person with a FICO of 700 or above to obtain the fairest loan terms.
Adequate income
Most loan lenders do not disclose the income thresholds that they consider adequate to qualify for a home equity loan. However, you must demonstrate your ability to pay off your debts through an income.
Low debt
Lenders of home equity loans can tell if you can get a loan based on a number called your debt-to-income ratio. Lenders generally require that your debt-to-income ratio stand at 43%, which means that your monthly debts should make up only 43% or less of your monthly income.
Good Loan-to-Value ratio (LTV)
Another factor often used by home equity loan lenders is the LTV ratio, which measures the loan amount requested against the current appraised value of your home. A good LTV percentage lies at 80% or less, and most lenders will accept your loan request if you fall into this bracket.
A good payment history
If you haven't paid your bills on time in the past, it will be harder for you to get a home equity loan or HELOC. A history of on-time payments sets you on the right path to qualifying for a home equity loan.
The benefits of a home equity loan
The above qualifications are bound to help you secure a home equity loan or a HELOC. Home equity loans offer various advantages, such as:
Lower interest rates
Home equity loans and HELOCs offer the benefit of lower interest rates as compared to other consumer loans since they are guaranteed by your home as collateral.
They are tax-deductible
If you use your home equity loan or HELOC to perform modifications to your house, the loan may be eligible for a tax deduction. This is a big relief because it may help you carry less in general.
Readily accessible cash
A home is a great asset that one can have. But if you need cash quickly for an emergency and have to sell your home, it may take a while. Home equity loans and HELOCs allow you to get cash quickly and easily by using your home as collateral. This lets you take care of your needs quickly.
As you can see, a home equity loan has a lot of benefits, the biggest of which is that it has lower interest rates. Also, the home equity loan works through eligibility requirements, so people that do not meet the required standards are filtered out.
How Much Money Can I Borrow with a Home Equity Loan?
How much you can borrow against your house is mostly based on how much home equity you have. Though the percentage varies from one lender to another, the amount of home equity loan that can be borrowed is typically between 80% and 85% of the appraised value of your home minus your mortgage balance.
For example, suppose the market value of your house is $200,000. If your home equity loan lender agrees to give you a loan of 85% of the market value of your home, then the 85% of the appraised market value will be $170,000. If you have an outstanding debt of $120,000 on your mortgage, then you are eligible for a $50,000 loan.
What are the Drawbacks of a Home Equity Loan?
There are several drawbacks to a home equity loan. These are:
Comparatively higher interest rates
Home equity loans have fixed interest rates. Hence, you could end up paying a higher interest rate than if you took a HELOC loan. Similarly, HELOC loans have variable interest rates, and thus, during the repayment period, the interest rates may end up being higher than if you took a home equity loan.
Your home serves as the collateral
Any slight default on payments could render you homeless. This serves as one of the biggest disadvantages of borrowing against your house.
Strict eligibility requirements
As stated earlier, to get the best loan terms, a credit score of 700 or above is necessary. Also, a very low debt-to-income ratio is required. These strict requirements are likely to lock you out if you are seeking a home equity loan to put your finances in order.
A high Loan-to-Value ratio
A good LTV ratio is one that is at least 805, meaning that you must remain with at least 20% of the equity of your home after borrowing a home equity loan. Such strict terms tend to disqualify a large majority of people.
May result in a tighter budget
If you take a home equity loan and still have your primary mortgage, you may end up with two mortgages, which means a tighter budget as your disposable income has been reduced. Similarly, if you are used to paying interest-only during the draw period of a HELOC loan, you may be forced to adjust to the large payments to be made during the repayment period.
Unexpected change in home value
In the unlikely event that the value of your home goes down due to market factors beyond your control, you will be stuck in an upside-down mortgage arrangement where the money you owe is greater than the value of your home.
Home equity loans have several disadvantages, and they may not always be the best option. It is advisable to use money from a home equity loan or a HELOC loan to do projects that will boost your financial advantage, such as going to college or improving the market value of your home. If you work as a first responder, you should consider the favorable loans offered to people in your line of work.
Check out the Boston Firefighters Credit Union website for more information.
The Best Way to Use Your Home's Value as Leverage
Your home’s value can work to your advantage when the real estate industry is performing well. You could use your home’s equity to obtain a home equity loan or home equity line of credit. Such a loan can be used for:
Home improvements – These can raise the market value of your home for more profit during sale. Furthermore, this makes your loan tax deductible.
Higher education expenses – As a parent, you can help your child avoid student loans by using your home equity loan to pay for their college.
Debt consolidation – You can pay off all your debts with a home equity loans and just pay monthly installments for one low interest rate loan.
Emergency expenses - If faced by an unexpected emergency, you can make use of the value of your house to deal with the unexpected issue then slowly work to pay back the borrowed amount.
