If you need to borrow money and have enough equity in your home, getting a equity loan can be a good idea. A home equity loan allows you to borrow against your own home equity, usually at a lower interest rate than other types of loans.
However, this type of loan product is not suitable for everyone – it also comes with risks. Before you decide to use this loan option, make sure you fully understand what these risks are, what a home loan is and how it works.
What is a home equity loan?
A home equity loan, commonly referred to as a second mortgage, is a one-time fixed rate loan secured by your home equity. Because mortgages are secured by your home, lenders usually charge lower interest rates than for personal loans or credit cards.
For example, on June 23, the average mortgage rate was 5.36 percent, while the average personal loan rate was 10.49 percent and the average credit card rate was 16.09 percent. However, the interest rate you will receive on a equity loan, personal loan or credit card will vary depending on the lender, your credit score and income and other factors. If you have excellent credit, you can secure a lower interest rate.
How does a home equity loan work?
When you take out a home equity loan, a lender will approve a loan based on the percentage of equity you have in your home. Some lenders may require you to pay a closing fee. Once your funds are issued, you will have to repay the loan in fixed monthly installments that include capital and interest. Although the terms vary, home equity loans can be up to 30 years old.
Since the loan is secured by your home, this puts your home at risk if you can not repay what you have borrowed. If you default on the loan, the lender may foreclose on your home. In addition, this will cause serious damage to your credit score, making it more difficult for you to qualify for future loans.
If you use a home equity loan to make home improvements, the interest you pay on it can be tax deductible. According to the IRS, you can deduct the interest of a mortgage used to “buy, build or substantially improve” your home.
How To Calculate Equity In Your Home
Equity for your home represents the portion of your home that you actually own. is the current value of your home less the outstanding balance of your mortgage. To calculate the percentage of equity you have in your home, you need to divide the remaining balance of your mortgage by the estimated value of your home. If you need help estimating the value of your home or calculating your equity, use a equity computer.
For example, if the outstanding balance of your home equity loan is $ 100,000 and the estimated value of your home is $ 250,000, then you have 40 percent equity in your home.
Although lenders have different requirements for home equity loans, you usually need a credit score of at least the mid-600s, at least 15 percent to 20 percent equity in your home, fixed income and debt-to-income ratio (DTI) that is lower than 43 percent. Before applying for a home equity loan, check the minimum requirements of the lender to see if you qualify.
In addition, lenders typically have a maximum combined loan-to-value ratio of up to 85 percent. This means that you can borrow only 85 percent of the value of your home, minus the outstanding balance of your mortgage. For example, if your home is worth $ 250,000 and you owe $ 100,000, 85 percent of the value of your home is $ 212,500. If you deduct your balance from this amount, you receive $ 112,500 – this is the maximum amount that your mortgage could be.
Differences Between a Mortgage and a Housing Equity Credit Line (HELOC)
A home equity loan is not your only option for borrowing against your own home equity. Instead, you can use a home equity (HELOC) credit line.
While a HELOC is also secured by equity in your home and has similar borrowing requirements, it works differently than a home equity loan. A HELOC is similar to a credit card in that you can borrow money as needed up to a certain limit. Unlike mortgages, HELOCs usually have variable interest rates. Although average HELOC interest rates tend to be lower than mortgage rates, your monthly payments could increase if interest rates rise.
Also, a HELOC is accompanied by a draw period and a repayment period. During the lottery period, which usually lasts 10 years, you can borrow money from the credit line and be responsible for making interest-only payments. When this period expires, the repayment period begins and you must repay the principal, plus interest. During the repayment period, which often lasts 10 to 20 years, you can not borrow money from HELOC.
The bottom line
When deciding if it’s a good idea to take out a home equity loan, consider the benefits and costs. Although home equity loans usually come with lower interest rates than other types of loans, you run the risk of losing your home if you are unable to repay your loan. If you need more flexibility in payments, consider choosing a HELOC.
However, if you decide that home equity lending is not right for you, look into different loan options.