If you have been investing in house repairs and improvements, chances are your house value is higher than it was when you buy it. You can get a consumer loan based on that equity, that’s what we call a Home Equity Loan.
Although it can be a very helpful alternative to invest in a business or even in more home repairs, home equity loans carry a series of benefits and risks you should be aware of before taking one.
All You Wanted To Know About Home Equity Loans
Home Equity Loans Explained
They are also called “second mortgages”, which makes a lot of sense since you need to have already a mortgage to get access to it.
The amount of your home equity loan is based on the difference between your actual mortgage balance, and the house’s current market value. These types of loans tend to have fixed-rate interests.
The equity of the house is the collateral for your lender, and borrowers usually can get a loan for up to 90% of the home’s appraised value, considering, of course, credit score and payment history.
How Do Home Equity Loans Work?
The way these loans work is pretty similar to traditional ones. There is usually a fixed repayment term, and borrowers need to make regular payments. And just as with any other loan, in the event of the borrower refusing to pay, the lender can foreclose the house.
You can take advantage of the equity you have built up in your house through years with an equity loan. This may work to keep improving the house, expand or make repairs. However, keep in mind any mortgage takes your house as collateral, so you want to make sure you understand the risks and benefits.
For instance, if the estate value drops down, you will end up owing even more than what your house is worth.
Equity Loan Amounts And Requirements
Banks have similar eligibility standards for regular and equity loans, however, home equity loans also take into consideration the value of the property and your loan payment history. All of that comes to the table in what’s called a Combined Loan-To-Value Ratio (CLTV ratio).
Let’s break it into an oversimplified example:
Let’s say the value of your house is $300k and you still owe $150k from your first mortgage, then you find a lender that offers a CLTV ratio of 80%
$300,000 (house value) X 80% (CLTV ratio) = $240,000
-$150,000 (what you still owe)
Equals $90,000 (the max loan you can get)
However, remember banks will also consider your FICO score and your first mortgage payment history to determine the max amount you can get.
Also, keep in mind you may end up paying closing costs and fees associated with your first mortgages, such as origination, appraisal, or recording fees.
Home Equity Loan And Home Equity Line Of Credit (HELOC)
A home equity loan will lend you a lump amount, usually with a fixed interest rate, and terms can go from 5 to 15 years.
While a HELOC works a little more like a credit card, where you can draw money multiple times, within a maximum loan limit. These types of loans tend to have variable interest rates. Compared with other unsecured loans, such as credit cards, with an equity line of credit, you’ll be paying less financing fees.
What Is The Difference?
A HELOC is very similar to a credit card. But instead of getting a real card, you can only access those funds through a transfer, writing a check, or through a previous credit card connected to your account.
They usually have variable interest rates, but some lenders can offer a fixed rate for the first years. One of the benefits is that usually there are few-to-none closing costs.
Home equity credit lines tend to have two phases
A draw period (usually 10 years)
During this period you can withdraw the loan amount and use it as you want. Typically you will be required to make small payments that cover mostly interests, but you can choose to make bigger payments to lower the principal. Depending on your particular situation, some lenders can extend the draw period.
Repayment phase (usually 20 years)
You can no longer access additional funds once in the repayment phase. During this period you need to clear the debt completely plus interest.
Keep in mind If you choose to pay interest only during the draw period, the number of your monthly payments can even double when in the repayment phase.
Home Equity Loans Can Become Tax-Deductible
After the tax reform from 1986, home equity loans became popular. Said reform eliminates deductions for the interest on most consumer purchases, except for interest in service of residence-based debt.
In 2017, the tax cuts and jobs act made big changes to the interest deductions. According to it, you can get an interest deduction only if you use the loan to keep improving the house, because that way you only keep increasing the value of the house, meaning, the collateral.
When you use the loan to consolidate other debts, buy a new car or pay to start a new business, that is not tax-deductible.
You Can Back Out From A Home Equity Loan
You have up to 3 days to cancel a credit agreement as long as the collateral is your actual residence. According to federal law, you have until midnight of the third business day to back out from the transaction after you sign the contract.
You must give notice of the cancellation to your lender in writing. It won’t work if you do it on the phone or face-to-face. If you already paid any fees for the transaction, the lender has up to 20 days to give the money back.
Things To Beware Of When Looking For A Home Equity Loan
Unfortunately, unscrupulous lenders and institutions use these and other types of loans with bad intentions. They usually target adult citizens or people with bad credit histories.
● More Than What You Need
Is your lender pushing you to get a bigger loan than what you asked for? Or are they encouraging you to refinance again and again? That’s a red flag right there. Constant refinancing can increase your debt and make it unpayable, which gives them the right to claim the collateral.
It is a common thing to have some sort of mortgage insurance for some types of loans, such as the FHA, but some lenders pre-pack all types of unnecessary insurances and fees on the loans they offer. Read everything and don’t be afraid to ask about anything that doesn’t seem clear to you.
● Misleading Offers
Some lenders will offer you hard-to-believe terms and interest rates to bait you in, and then change the rules when you are about to sign in. Take your time to read carefully any document before accepting and call out anything that looks shady.
● Paying Capacity Vs Equity
The most important thing to consider for any legitimate lender is your ability to repay, which lets you know they want you to repay the loan. Any lender that offers a loan based on your home equity, is probably most interested in taking your house.
● Beware Of Extremely Low Monthly Payments
The amount you pay every month is determined by your income and debt, but also by the interest rates that the lender charges to make it profitable for them. If your monthly payments don’t cover enough interest or enough of the principal, you will be just rolling out more debt. Ask yourself “Is this a good business for the borrower”? If the answer is no, then their business is probably elsewhere, for instance in foreclosing your house.
● Home Improvement Loans
Sometimes a contractor will call your door and offer you an incredible deal to remodel your kitchen, roof, backyard, or any other part of the house. They may say you don’t even need money upfront because they can help you get a loan for it. As all paperwork seems to be about the remodeling, they will ask you to sign a lot of confusing contracts that can set you up for insane lending terms and conditions.
Beware of anything that looks suspicious or “too good to be true”.
Is It An Equity Loan Or Equity Line Of Credit For Me?
First of all, keep in mind both options put your house in the line. The best you can do beforehand is to grab pen and paper and crunch the numbers on your income, current debt, and expenses, to make sure you can afford a new monthly payment.
Also, it is really important to remember that, after the draw period, your payments can increase up to two times what you were paying.
Here are some of the most relevant pros and cons you want to consider before signing in
● If you already have a mortgage, a home equity loan is easy to get
● Interest rates below average
● Tax breaks when you use the loan to improve the house
● Equity loans tend to have fixed interest rates
● There is a real risk of losing your house if you stop making payments
● If the market crashes (as in 2008) you may end up owing more than the value of the house
● When their draw period ends, you may end up paying up to twice the original monthly amount. This can flip out many borrowers
● Many lenders have minimum withdrawal requirements
Frequently Asked Questions About Home Equity Loans
Home equity loans can be a great help to improve your house, or even to finance some other things, however, you must remember they also carry big risks. Take your time to evaluate if it is worth it.
And if you already decided a home equity loan or line of credit is what you need, then you may want to take a look at the most asked questions about them.
● How Much Money Can I Borrow On A Home Equity Loan Or Credit Line?
Just as with any other type of loan, there are many factors at play, such as your FICO score, income, and debt, but what sets the maximum loan sum is the Combined Loan-To-Value ratio (CLTV)
The CLTV is the difference between the market value of the house and the loan amount you owe to the lender. Most lenders can offer you between 80% to 90% of the CLTV ratio.
● What Is The Interest Rate For A Home Equity Loan?
You need to remember there are two types: Home equity loans and home equity lines of credit.
Home equity loans tend to have fixed interest rates for the whole term of the mortgage. While home equity lines of credit work pretty similar to a credit card. That means you can withdraw multiple times during the draw period (that usually lasts 10 years) with a variable rate interest.
● Are Home Equity Loans And Home Equity Lines Of Credit (HELOC)The Same Thing?
They both work similarly, but in practice, they are very different.
A home equity loan is a one-lump sum of money you can get, and repay monthly for the coming years. These loans tend to have fixed interest rates, and also fixed monthly amounts.
A HELOC gives an available amount you can withdraw from, at any time during the draw period. These loans tend to have variable interest rates, but you will also be required to pay different amounts during the draw period (usually 10 years) and the repayment phase (usually 20 years). This is important because the amount during the repayment phase can be significantly larger.
● Will I Be Paying The Same Amount During The Whole Term?
Yes with a Home equity loan.
Although, when talking about Home Equity Lines of Credit, some lenders offer fixed rates for the first years too. Even with that, remember after the draw period your monthly payments will increase, no matter the interest rate.
● Can I Back Out From A Home Equity Loan?
Yes, only if the collateral is your actual residence. You have up to 3 days after the deal gets closed and you need to notify your lender by writing.
● What To Do If I Think My Lender Is Taking Advantage?
You can look for assistance from the Federal Trade Commission or contact your local authorities.
● How To Differentiate A Good Deal From A Scam?
Ask yourself “Is this loan a good deal for the borrower?” Legitimate borrowers will look at your spending ability, your income, and debt, and they will offer you a clear monthly plan according to that.
Unscrupulous lenders will offer you too-good-to-be-true deals with minimum monthly payments, that sometimes don’t even cover the interests.
Home equity loans can help you overcome financial difficulties, support your family well being, or finance some of your projects. Just keep in mind, as with any other mortgage loan, they carry some risks.
Take your time to evaluate which type of home equity loan you need, but most of all which type you can pay with no problems for the upcoming years.
If you need to take a couple of steps back and find out how exactly mortgage loans work, you may want to take a look at this short guide [ “Mortgage loans for first-time buyers].
And if you still have questions about which type of loan works the best for you, call us today at 559-400-7580 to get honest and reliable service.