There are times when a credit card won't cut it. You may need to pay tuition or have major repairs done to your house. Or maybe you have a great deal of high-interest debt and are looking for a way to consolidate loans to make your payments easier and, in the long run, cheaper. You may need more money than you can get a personal, unsecured loan for. That's when it's time to look at a home equity loan or home equity line of credit (HELOC).
This article covers the basics of home equity loans and HELOCs. For more information, or if you are interested in getting a home equity loan or line of credit, check out our reviews on home equity loans and HELOCs.
What is a Home Equity Loan?
A home equity loan lets you put your house up for collateral on a loan, even if you still owe money on it. The lenders look at how much of your house you own – i.e., how much the house is worth versus how much you owe. This is called equity. You generally need at least 20 percent equity to qualify for a home equity loan. The money is yours to use as you wish.
A home equity loan vs. a mortgage: Since you most likely already have a mortgage on your home, what you really need to know is the difference between a refinanced mortgage and a home equity loan. Refinancing usually covers the amount you still owe on the house, though you can cash out on the equity and get more to use for, say, repairs. You've essentially replaced one home loan with another.
Home equity loans are specifically to use your home's equity for another purpose. Thus, home equity loans are less than how much you owe. In addition, closing costs are smaller, as are fees. However, you then pay your mortgage and the home equity loan. It is a second home loan.
A home equity loan vs. a HELOC: A home equity loan is borrowed in a lump sum and paid back over 15 to 30 years. With a HELOC, the lender authorizes you a maximum amount to borrow over a draw period, usually 10 years. However, you only draw what you need and pay back as you can in that period. At the end of the draw period, you have a set time to pay the outstanding balance, usually 15 years.
The nice thing about a HELOC is that while you have a set maximum you can borrow, you do not need to borrow that much, and you can borrow only as much as you need over time and pay back as you go. This is great when you have construction expenses, for example. Keep in mind, however, that some lenders require you to withdraw a certain amount a given number of times a year and may penalize you if you close your HELOC early.
When Should I Consider a Home Equity Loan or Line of Credit?
The best reason for a home equity loan or HELOC is to pay for a large expense that's also good long-term or lifetime investment. After all, you are putting your house on the line. Tuition and home improvement are the top reasons.
When doing home improvements, be sure they will contribute to the quality of your life. Some people put a lot of money into modernizing a home in hopes of increasing its resale value. This can be a mistake. The housing market can slump, or your improvements, especially in design, may turn off a potential buyer if they don't like the style. Unless you need serious updating, like replacing the pipes or bringing the air conditioning to 21st century standards, you may be better off with a fresh coat of paint and a thorough decluttering.
It can be tempting to take out a home equity loan to consolidate debt, buy cars or pay for weddings. This is not a wise choice. While you may be able to get a better interest rate and lower monthly payment, you are in essence spending 15 years to pay back expenses that should be shorter term. That loan could last longer than your next two or three cars! Also, if you are using it for debt consolidation and you don't fix your spending habits, then you simply dig yourself further into the hole – and if you can't keep up the payments, you could lose your house.
Think carefully about taking out a home equity loan or HELOC.
How Does a Home Equity Loan Work?
In general, taking out a home equity loan or HELOC is similar to a mortgage. You need to show your credit history, your income and your home's worth (which may require an appraisal.) In addition, lenders will assess you on your ratio of debt to income, the loan amount you want versus how much the home is worth (called loan to value, or LTV), and how much you still owe on your home versus what it's worth.
What are the interest rates? Just like with mortgages, you may have a choice of a fixed or adjustable interest rate. A fixed rate, like the name says, stays the same for the life of your loan no matter what the prime rate does. Adjustable rates follow the government-designated prime interest rate, usually at a set number of percentage points. For example, if the lender sets the additional percentage as two points, and the prime rate is 3.25 percent, your loan interest is 5.25 percent. If the prime rate rises to 5 percent, your interest rises to 7 percent.
Your contract will tell you the points and the maximum percentage your loan can reach. Usually, lenders not only set a ceiling for the life of the loan but also the maximum it can rise in a year.
Sometimes, a lender will give you a super-low introductory rate, then raise it after six months or a year. If you agree to this, be sure you understand how much they can raise it and how they decide.
HELOCs usually work on adjustable rates, but lenders will let you fix your interest rate temporarily for a fee. For example, imagine you're seeing rates go up, and you know you'll have to take out a lot of money over the next six months. You can pay to freeze the interest rate, betting that the rates will rise and you'll save money with the lower interest.
Are there fees? Most home equity loans carry fees and closing costs similar to mortgages, but often less expensive. Most lenders don't charge fees or closing costs on credit lines, except perhaps an appraisal fee to verify the worth of your home. However, you may be charged some fees, like annual maintenance charges and transaction fees, each time you use the account, or inactivity fees if you don't use the account. Be sure to ask and read your contract carefully, then decide if those fees are worth it.
Can I deduct the interest from my taxes, like I do with my mortgage? Tax codes are difficult and ever-changing, so ask your tax consultant to be sure. However, in general, you can claim the interest against your taxes, which is an advantage over a personal loan. However, this is only applicable if the amount you borrow doesn't exceed the fair market value of your home, or (at the time of this article) over $100,000 for a couple. You don't get tax benefits for anything above the value of your home.
How much equity do I need? Usually, you can borrow up to 80 percent of your home's equity value. However, the more equity you've established, the more appealing your application is. Be wary of lenders who want to lend you more than your home is worth. Remember, you are still making payments on your home, and if you can't keep up on either the mortgage or the home equity loan, you could lose your house.
Can I get a home equity loan if I have bad credit? Yes, because house is the collateral. Be able to show you're a good financial risk, such as with a steady income and a good current history of paying off debts. You probably won't get as good a deal as if you had good credit, of course.
Can I use my rental as collateral? That depends on the bank. Several of the lenders on our Home Equity Lending Services site allow rentals or vacation homes as equity.
What if I get the loan, then change my mind? You have three business days to cancel the contract, by law. After that time, you will have the money. If you realize you do not want or need the loan, then you need to pay it back. You may incur a prepayment penalty, particularly on a HELOC.
You've put a lot of money and work into your home. With a home equity loan or line of credit, your home can now work for you. However, you should be sure that if you take out one of these loans you are doing so for a good reason – one that improves your life in the long term – and that you are able to handle the extra payments of such a loan.