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Home Equity Loans

The Basics of Home Equity Loans

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House model resting on money
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Home equity loans allow you to borrow against the value of your home. These loans appeal to borrowers who find that they can borrow relatively 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 add other 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:

  • Home equity loans typically have a lower interest rate (or APR)
  • They are easier to qualify for if you have bad credit (sometimes)
  • Interest costs on a home equity loan may be tax deductible
  • Borrowers can qualify for relatively large loans with this type of loan

Most of those benefits (except for the tax deduction) are available because home equity loans are generally safe loans for banks to make: the loan is secured by your house as collateral. If you fail to repay, the bank can take your property, sell it, and recover any unpaid funds. 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).

Of course, banks have to be careful not to lend too much (as they did in the housing crisis) or they risk major losses. To protect themselves, lenders try to make sure that you don’t borrow any more than 85% 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.

Logistics

When you get a home equity loan, you get a lump-sum of cash, and you repay the loan over time with fixed monthly payments. Your interest rate is set up-front, and each payment reduces your loan balance and covers some of your interest costs (it is an amortizing loan).

If you don’t need all of the money at once, you can also consider a home equity line of credit (HELOC). That option provides a pool of money that you can draw from if and when you need it, and you only pay interest on any money that you’ve actually borrowed. However, be aware that banks can close or cancel a HELOC before you’ve had a chance to use the money, and the interest rate on a HELOC generally changes over time.

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 loan.

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 the most important expenses; things that will improve the value of your home or improve your income are good examples.

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 the deal is legitimate.

How to Find the Best Home Equity Loans

Finding the best home equity loan can save you thousands of dollars – at least. In order to get the best loan, I recommend that you:

  • Shop around. Try a variety of sources (banks, brokers, and credit unions)
  • 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 really 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 to cover the payments if something happens. You may or may not need insurance, and nobody can force you to use it. If you’re going to include insurance as part of a home equity loan, go with monthly premium payments – not up front – so that you only pay for what you use (assuming the insurance is just for the home equity loan).

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