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Should You Get a Home Equity Loan?

what is a home equity loan

You’ve heard the term home equity loan before, but you’re not quite sure what it entails. Maybe you’ve been meaning to update your home’s outdated plumbing, but you don’t have the funds to pay for it. Or perhaps you have significant credit card debt, and you’ve heard of people consolidating it and paying it off with a home equity loan (HEL).

There are many reasons why people consider using home equity loans. We’ve weighed the pros and cons so you can figure out if a home equity loan is right for you.

Basic home equity loan requirements

The amount of money you can borrow is based on your home’s equity, the appraised value minus what you owe on your mortgage. Let’s say your home is valued at $200,000. If you have $110,000 left on your mortgage your equity is $90,000.

That doesn’t mean you can borrow all $90,000 — typically, the maximum amount you can borrow is 85% of the equity you hold in your home, according to the Federal Trade Commission (FTC). You may calculate your borrowing power using the loan-to-value ratio (LTV). If your lender lets you borrow up to an LTV of 85% using the earlier example:

$200,000 x 85% = $170,000 (LTV ratio)

$170,000 – $110,000 = $60,000 (maximum LTV ratio, minus what you still owe)

Lenders will also take your credit history, income and other factors into consideration:

Credit history. In order to determine the likelihood that you will pay back your loan, prospective lenders will look at your credit history and credit score.

Income. Lenders will check to make sure your income is high enough to cover the cost of the debt you’re taking on. Your existing debt-to-income ratio should be less than 49%, though some banks require a ratio that is less than 43%.

Ability to repay. Lenders may also look at other assets and monthly expenses to determine your ability to repay the home equity loan.

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Good uses for a home equity loan

Home improvement topped the list of reasons homeowners took out a home equity loan, according to a recent LendingTree study, with debt consolidation a close second.

Here are reasons you might consider a home equity loan:

  1. Home improvements. Some of the benefits include a potentially lower interest rate than you’d get on a personal loan and a tax deduction on the interest if you use the loan to buy, build or substantially improve the home securing it. Such improvements may increase the value of your home.
  2. Debt consolidation. If you have significant high-interest credit card debt, you may consider consolidating that debt and paying it off with a home equity loan. The main benefit of taking out a home equity loan to pay off credit card debt is that you will likely be able to secure a lower interest rate than your current credit card rates or even that of a personal loan. Just keep in mind that this comes with risks, as you are trading unsecured debt for secured debt. If you don’t pay off the debt, you risk losing your home.
  3. Education expenses. Some consumers take out a home equity loan to pay for their children’s education, as the interest rate is likely lower than that of student loans. This could also be a good idea if you’re paying for your own advanced degree, as you will hopefully be furthering your own career and increasing your future potential earnings.
  4. Emergency expenses. People can tap into their home’s equity to pay for emergency expenses due to the loss of a job, a costly medical procedure or other major life events. But remember that it may take weeks or even months to completely the closing process for an home equity loan.
  5. Long-term care. Some senior citizens borrow against their home’s equity to finance long-term care, according to research published in the Medicare & Medicaid Research Review.

Most consumer credit experts warn against using home equity loans for large purchases, such as a vacation, luxury item or wedding. They also caution against using home equity loans for weekly expenses, such as groceries, utilities and other bills. If you need to borrow against your home to cover these costs, you likely need to reassess your spending habits. Other ways you could leverage your home equity aren’t as clear-cut — there are pitfalls when using home equity to purchase a second home, but using it to purchase a rental home might be a good investment.

In addition, most experts warn against using a home equity loan to pay back high-interest student loan debt because it can impact your taxes and you’re putting your home on the line, according to the Consumer Financial Protection Bureau (CFPB).

Home equity loan vs. home equity line of credit

In addition to HELs, consumers can also obtain a home equity line of credit (HELOC). The main difference between the two is that home equity loan funds are distributed in a lump sum, while HELOC funds are structured as a revolving line of credit.

Here’s everything you need to know about the differences between a home equity loan and a HELOC.

Home Equity Loan vs HELOC
Home equity loan (HEL) Home equity line of credit (HELOC)
How funds are distributed The lender loans you the funds as an upfront lump sum. In a revolving line of credit. You can borrow against your HELOC as you need much like a credit card.
Interest rate Fixed Variable, though a HELOC may have a fixed APR during its repayment period
Repayment term You pay the loan back in equal monthly payments, much like you would pay your mortgage. Payments may vary depending on whether rates go up or down. They may be lower during the borrowing period and higher during the repayment period. You might also be required to pay a “balloon” payment at the end of the loan’s term.
Term 5-30 years 5-10 years to borrow funds, with a repayment term of 10-20 years
Collateral required Your home Your home
Best for Financing home repairs or renovations, college education, long-term care or consolidated credit card debt. Home repairs or remodeling that will take place over the course of several months or years.

The benefits of a home equity loan

  • Access to a lower interest rate. Typically, home equity loans have an interest rate that is lower than other forms of credit, such as a personal loan or a credit card.
  • Potential to increase your home’s value. If you’re using the loan to either make repairs or renovations to your home you will likely be increasing your home’s value.
  • You’re increasing your potential future earnings. If you’re using a home equity loan for your college education, you will potentially obtain a degree that will increase your future earnings.
  • Potential tax deduction. If you’re using the home equity loan for home repairs or renovations, you might be able to deduct the interest on your taxes. Keep in mind that this deduction is not possible if you’re using the loan for other purposes, such as education or paying off credit card debt.

The drawbacks of a home equity loan

  • Your home is on the line. The major drawback of a home equity loan is that your house is on the line. If you don’t repay the loan, you might be forced to sell your home, or your lender might foreclose.
  • In some scenarios, you’re trading unsecured debt for secured debt. If you take out a home equity loan to pay off consolidated credit card debt, for example, you’re trading unsecured debt for secured debt. With unsecured debt, the biggest risk is being sued. With secured debt, the biggest risk is losing the roof over your head.
  • Most come with fees. Home equity loans typically come with closing costs and other fees, such as underwriting, document preparation and appraisal fees.
  • You’re taking on more debt. The bottom line is that when you’re taking out a home equity loan, you’re taking on more debt. This will hit particularly hard if you’ve spent the past few years or decades working to pay off your home. Speak with a credit counselor or other consumer credit expert on whether taking out a home equity loan is the best financial decision for you.

Where to get a home equity loan

Like any loan you would take on, you should shop around for a home equity loan. The FTC recommends shopping around with banks, savings and loan associations, credit unions and mortgage companies. You can also ask family members or friends who have taken out a home equity loan in the past for any recommendations they might have.

The FTC adds that regardless of where you obtain a loan, you should ask lenders the following questions:

  • What are the different loan plans available to me?
  • What is the monthly payment?
  • What is the interest rate?
  • What is the annual percentage rate (APR)?
  • What are the fees? (This can include application fees, loan-processing fees, underwriting fees, lender fees, appraisal fees, document preparation and recording fees and broker fees, according to the FTC.)

Keep in mind that you can always negotiate the terms of your loan with multiple lenders to find the right fit for you.

If you get to the closing and things don’t seem right, you can cancel the deal for any reason under the three-day cancellation rule without penalty.

Is a home equity loan right for you?

It depends on your unique situation. If you have good financial habits, no significant debt and are interested in taking on a home renovation project you’ve planned for years, a home equity loan might be right for you. But if you’re already in significant debt and are using a home equity loan to finance a lavish wedding, then it might not be the right call.

If you decide a home equity loan is right for you, make sure you do your due diligence, meeting with numerous prospective lenders and comparing offers to find the right loan for you.

 

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