What Are The Things
You Need To Know About
Home Equity Loans

“Home is a shelter from storms – all sorts of storms”

– William J. Bennett

Yes, it’s truly said! Your home can help you weather financial storms by providing you an opportunity to take out a home equity loan!

Many people tap into the equity of their homes for large but important expenses like home renovations, debt consolidation, etc.

One of the reasons being, the interest rates of home equity loans are comparatively lower than personal loans!

Yes, you heard it right!

But what exactly is a home equity loan? And how does it work?

Well, home equity is the part of your mortgage that you have already paid off! In other words, equity is your stake in the property!

That’s why a home equity loan is usually considered as the second mortgage! The reason being, you have taken out a primary mortgage while buying your home.

And while taking out a home equity loan, you are taking out another loan against your stake in your home! So, your home acts as collateral while taking out a home equity loan.

The money from the loan will be disbursed to you either as a lump sum amount or as a line of credit. And you have to make regular fixed payments (including both principal and interest) to pay off your home equity loan.

Usually, home equity loans are of two types:

1. Fixed-rate home equity loans

You can take out a single lump sum payment at a fixed rate of interest. And you can pay off your loan by a set amount of time ranging from about 5 to 15 years. Besides, your monthly payments are likely gonna remain the same throughout the repayment period as the interest rate will be fixed!

2. Home equity line of credit (HELOC)

In the case of a HELOC, your lender will approve a credit limit based on your equity in your home.

After that, you can take out a loan of any amount within that credit limit. You can withdraw money by credit cards or special checks. However, this draw period usually ranges from about 5 to 10 years, depending on the lender!

Once the draw period of a HELOC ends, the repayment period starts! You will have to repay the amount you have borrowed along with the current interest rate. And you won’t be able to take out any loan from your credit limit during this repayment period.

The repayment period of HELOCs varies with lenders. But in most cases, it ranges from about 10 to 20 years!

Besides, many lenders levy an annual fee even if you haven’t borrowed any amount from your available credit limit. So, check out your loan terms and conditions carefully before you opt for a home equity line of credit!

What are the eligibility requirements to take out a home equity loan?

Yes, like any other loan, you need to meet certain eligibility criteria to opt for a home equity loan. Generally, the eligibility requirements vary with lenders. But some of the important requirements are:

  1. 1

    You need to have your LTV (loan-to-value) ratio within 80% to 85% to qualify for a home equity loan. To find your LTV ratio, you have to divide the loan amount you want to take out by the appraised value of your home.

    The lower your LTV ratio, the higher your chances of loan approval. And if you have a good LTV ratio, you may get a preferable interest rate too!

  2. LTV (loan-to-value)

  3. 2

    Your credit score should be around 650 or higher. Having a decent credit score means you are responsible with your credit. And you are less likely to default payments.

    So, lenders check your credit score when you apply to take out a home equity loan. And if you have a good credit score, you can take out a home equity loan at preferable interest rates!
    Read: How to improve your credit score within 6 months

  4. 3

    Your debt-to-income (DTI) ratio should be around 43% or lower. In other words, the lower your DTI, the higher your chances of loan approval.

    To find your DTI ratio, you need to sum up all your monthly payments like principal, interest, taxes, homeowners insurance, etc. for your home along with any other debts.

    Then you have to divide the entire amount with your gross monthly income from all sources.
    So, calculate your DTI ratio before you plan to take out a home equity loan!

Once you qualify, you might think about how much you can borrow on a home equity loan?

Suppose, the current value of your home is $350,000. You have the remaining $240,000 to pay. That means, your home equity is $110,000 ($350,000-$240,000).

Now let’s say, your lender allows you to borrow up to 85% of your equity in your home.

Therefore, the amount that you can take out in a home equity loan is:
(0.85 * 350,000) – 210,000 = $87,500

So, in this scenario, you can take out a home equity loan of up to $87,500.

Are home equity loans a good idea?

Well, it depends on your financial planning! No doubt, a home equity loan helps you to borrow money for a definite time and at a fixed interest rate. But you have to make sure that you can repay your loan on time. Otherwise, your home could be at stake!

So, before you opt for a home equity loan, you need to weigh the benefits as well as the drawbacks too!

Let’s check out the pros and cons of home equity loans to help you decide in a better way!

    Pros:

  1. You can take out a home equity loan at a much lower interest rate than personal loans.
  2. A home equity loan usually comes with a fixed repayment period and a fixed interest rate. So, it would be quite easier for you to plan your finances accordingly to make monthly payments for loan repayment!
  3. The interest on your home equity loan is tax-deductible. However, under the new tax law, if you are using the home equity loan to renovate your home, then only the interest will be tax-deductible. And the total amount of home equity debt including your mortgage should be less than $750,000.

    Cons:

  1. Since you are keeping your home as collateral, any missed or late payments can lead to foreclosure of your home.
  2. If you want to sell your home, you will have to pay off your home equity loan immediately!
  3. You may have to pay a closing cost which ranges from about 2% to 5% of your loan amount.

How will you use your home equity loan?

Well, if you need a lump sum amount of cash for some major expenses, home equity loans can be the best bet for you. Yes, you heard it right! You can take out a home equity loan to:

  1. 1

    Pay off your unsecured debts

    Usually, unsecured loans have high APRs (Annual Percentage Rates) as you don’t need to keep any collateral. One of the common types of unsecured loans is credit cards.

    If you can’t pay off your outstanding balance amount in full and within the due date, you will have to make hefty interest payments.

    And gradually, the outstanding balance becomes a whopping amount to pay off. Besides, if you are trapped with multiple credit card debt, it would be more cumbersome to get rid of it.
    In this situation, taking out a home equity loan to consolidate your credit cards might seem a lucrative option! But is it wise to consolidate credit card debts with a home equity loan?
    Undoubtedly, you can take out a home equity loan with a much lower interest rate than your credit cards. And you can pay off your loan over a set period and with a fixed interest rate. But remember, you are keeping your home as the collateral. Any sort of discrepancies in making payments can lead to foreclosure!

  2. 2

    Improvement work of your home

    You can renovate your home by taking out a home equity loan. It will help to increase your equity in your home. Besides, the interest payments can be tax-deductible if you use the funds to improve or renovate your home.

  3. 3

    Additions to your home

    You can build an extra room that you might have been planning for so long. It will help to increase the value of your home. So, you won’t have to spend money from your savings and make the improvement by taking out a home equity loan!

    So, the bottom line is, a home equity loan can be a source of cash if you need it for some major expenses. Besides, as I mentioned above, I would suggest taking out a home equity loan for some major expenses that can help you to improve your financial life!

    And please make sure to read the terms and conditions before opting for a home equity loan. If needed, you can make a plan on how you are gonna repay the loan.
    Remember, you are risking your shelter to take out a home equity loan. So, don’t tap into the equity in your home unless it’s too necessary!