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 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
- Interest costs on a home equity loan may be tax deductible
- Borrowers can qualify for relatively large loans with this type of loan
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.
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 pitfalls of these loans. The main thing 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 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. 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 Home Equity Loan Tips
To make the deal work out in your best interest, make sure that it is the right deal in the first place. 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. Make sure that taking the loan will not overburden you.
Review and consider insurance to cover the payments if something happens. You may or may not need insurance. If you’re going to include it in your program, try to pay the premiums monthly – not up front.