If you own a home and need extra cash, you may be able to use your home equity as a source of funding. Home equity is the difference between the current market value of your home and the amount you owe on your mortgage. Home equity loans are a type of loan that let you borrow a lump sum of money against your home equity at a fixed interest rate and term. Home equity loans can be a convenient and affordable way to finance various expenses, such as home improvements, debt consolidation, education, or medical bills. However, they also come with risks and costs that you should be aware of before you apply.
How do home equity loans work?
Home equity loans work similarly to primary mortgages, except that they are second liens on your property. This means that they are subordinate to your first mortgage, and that the lender can foreclose on your home if you default on the loan. Home equity loans are also known as second mortgages or home equity installment loans.
To get a home equity loan, you need to apply with a lender, such as a bank, credit union, or online lender. The lender will check your credit score, income, debt-to-income ratio, and other factors to determine if you qualify for the loan, and what interest rate and terms they can offer you. The lender will also appraise your home to determine its current market value and your available equity.
The amount you can borrow with a home equity loan depends on your equity, your creditworthiness, and the lender’s policies. Typically, lenders will let you borrow up to 80% or 85% of your home’s value, minus your outstanding mortgage balance. For example, if your home is worth $300,000 and you owe $200,000 on your mortgage, you have $100,000 in equity. If the lender allows you to borrow up to 80% of your home’s value, you can get a home equity loan of up to $40,000 ($300,000 x 0.8 – $200,000).
If you are approved for a home equity loan, the lender will either send you the loan funds directly, or pay off your existing debts on your behalf, if you are using the loan for debt consolidation. You will then have one loan to repay, with a fixed interest rate, monthly payment, and repayment term. The term of a home equity loan can range from 5 to 30 years, depending on the lender and the amount you borrow.
What are the benefits of home equity loans?
Home equity loans have several benefits, such as:
- Lower interest rate: Home equity loans usually have lower interest rates than other types of consumer loans, such as credit cards, personal loans, or car loans. This is because they are secured by your home, which reduces the risk for the lender. A lower interest rate can save you money on interest and help you pay off your loan faster.
- Fixed rate and payment: Home equity loans have a fixed interest rate and payment, which means that they will not change over the life of the loan. This can make it easier to budget and plan your finances, as you will know exactly how much you have to pay each month and when you will be debt-free.
- Tax deduction: Home equity loans may be eligible for a tax deduction, if you use the loan to buy, build, or improve your home. You can deduct the interest you pay on the loan, up to a certain limit, depending on your tax situation. However, you should consult a tax professional before you apply for a home equity loan, as the tax rules may change or vary depending on your circumstances.
What are the drawbacks of home equity loans?
Home equity loans also have some drawbacks, such as:
- Risk of losing your home: Home equity loans are secured by your home, which means that if you fail to repay the loan, the lender can foreclose on your home and sell it to recover the debt. This can result in losing your home, your equity, and your credit score. Therefore, you should only take out a home equity loan if you are confident that you can afford the payments and that you have a stable income and financial situation.
- Fees and charges: Home equity loans may come with fees and charges, such as origination fees, appraisal fees, closing costs, or prepayment penalties. These can add to the cost of the loan and reduce the amount of money you save. You should compare the fees and charges of different lenders and look for the lowest APR, which includes the interest rate and any fees.
- Reduced equity: Home equity loans reduce your equity, which is the amount of ownership you have in your home. This can limit your ability to sell or refinance your home in the future, or to take out another home equity loan or line of credit. You should also be careful not to borrow more than your home is worth, as this can result in negative equity, which means that you owe more than your home is worth.
How to compare and choose the best home equity loan for you?
To compare and choose the best home equity loan for you, you should consider the following factors:
- Interest rate and APR: The interest rate and APR are the most important factors, as they determine how much you pay for the loan. You should look for the lowest APR possible, and compare the APRs of different lenders and loan options. The APR includes the interest rate and any fees, and reflects the true cost of borrowing.
- Loan amount and term: The loan amount and term are the amount of money you borrow and the length of time you have to repay it. You should only borrow what you need and what you can afford to repay, and choose a term that fits your budget and goals. A shorter term means a higher monthly payment, but less interest. A longer term means a lower monthly payment, but more interest.
- Fees and charges: You should also check if the lender charges any fees or penalties for the loan, such as origination fees, appraisal fees, closing costs, or prepayment penalties. These can increase the cost of the loan and reduce the amount of money you save. You should look for a lender that offers low or no fees, or that waives or reduces the fees for certain borrowers or situations.
- Customer service and reputation: You should also consider the lender’s customer service and reputation, as well as the ease and convenience of the application and funding process. You should look for a lender that has positive reviews, responsive support, and transparent policies. You should also check the lender’s accreditation, ratings, and complaints with the Better Business Bureau or other consumer protection agencies.
Where to get a home equity loan?
There are many lenders that offer home equity loans, such as banks, credit unions, or online lenders. You can use online tools, such as Bankrate or NerdWallet, to compare different lenders and options. You can also check your prequalified rates with multiple lenders without affecting your credit score.
Before you apply for a home equity loan, you should check your credit score and report, and improve them if possible. You should also calculate your home equity and your debt-to-income ratio, and make a budget and a plan to repay the loan. A home equity loan can be a useful tool to access your home equity and finance your needs, but only if you use it wisely and responsibly.