What Are the Pros and Cons of a Home Equity Loan?

/ 01:27 AM January 16, 2019

A home equity loan is a great way to obtain money for home improvement or other projects. It allows you to borrow against the value of your home. Home equity loans have advantages over other types of loans, but there are disadvantages as well. Learning the pros and cons of a home equity loan can help you make the right financial decision.

What is a Home Equity Loan?

A home equity loan is a loan that takes advantage of the equity in your home. You can borrow money based on your home’s value, over any mortgage obligations. It is considered a second mortgage, the first being the loan you secured to purchase your home in the first place.

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There are two options for borrowing money with a home equity loan:

  1. Like any other loan, you can elect to receive the entire amount of your home’s equity up front. You would then repay the loan over time in smaller installments. This option features a fixed interest loan for the life of the loan. You pay interest on the entire amount.
  2. The more flexible option is called a home equity line of credit, or HELOC. With this loan, you are approved for a maximum amount, depending on your home’s equity, and simply borrow what you need from that amount. This leaves money left over in the loan, which you can borrow in the future when needs arise. Interest rates are variable, and you only pay interest on the amount you actually borrow.

Loan to Value Calculator

A loan to value calculator can help you determine if there is enough value, or equity, in your home above your mortgage obligations to secure a loan against it. It adds the outstanding balance of your first mortgage and any other liens on the property, such as tax liens. It then weighs this amount against the value of your home, which could be either its market value or current appraised value. This will give you your loan-to-value ratio. There are many versions of this calculator available online to do these calculations for you.

Pros of a Home Equity Loan

Home equity loans provide access to large amounts of money, depending on how much value, or equity, your home has built up. Your first mortgage has limits, but as long as your home has built plenty of equity above that loan, you can borrow more money than you could have with your first mortgage.

Home equity loans are easier to qualify for than other types of loans. Your home is used as security for the loan, so it’s easier to qualify than when you were initially buying the home.

A home equity line of credit allows you to borrow multiple times from the same maximum loan. This can help when sudden expenses show up.

A line of credit also allows you to make smaller repayments during the early phase of repaying the loan. This is called a draw period and might last about 10 years.

Home equity loans do not limit you on what you can use them for. As long as your property is worth more than you owe on it, the money yours to do with anything you like, such as home improvement, college tuition, starting a business, and other costs.

These loans carry a lower interest rate than other methods of borrowing money, such as credit cards. This keeps the cost of the loan low.

Cons of a Home Equity Loan

The main risk with home equity loans is the fact that you are using your home to secure the loan. This means that if you cannot keep up with the payments, you could risk losing your home. Defaulting on the loan will entitle the lender to foreclose on your home and sell it to recover the rest of the loan. If you have other debts, such as credit cards, you will want to consider whether you will be able to add another one.

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A home equity line of credit is very flexible, but your lender could freeze it before you can use the money. These freezes are often sudden and unexpected.

During the draw period of a home equity line of credit, payments are smaller, but once that period ends, payments will rise in order to adequately pay off the loan.

Though low interest rates can keep the cost of securing a home equity loan low, closing costs are often higher, which can offset the low rates and even increase the cost of the loan.

How to Get a Home Equity Loan

Home equity loans are easier to secure than other loans and the process is pretty straightforward. You apply with a lender, they check your credit and make a decision, and you receive your loan. There are a few considerations to take into account, though.

When you apply, you should do so with several lenders. Make sure to compare the costs of each lender, including interest rates and closing costs. Don’t assume that your bank is your only option – they may not give you the best rate or they may include higher closing costs.

The lender will perform a credit check before they considering loaning to you. Make sure your credit score is decent – most lenders look for a score of at least 620. The main consideration will be your payment history. The lender will want to be sure that you have a good history of paying on time. Get a copy of your credit report to make sure there aren’t any issues.

The lender may also require an appraisal of your home. They may insist on their own appraiser to do the job or at least require documentation of the appraisal.

Other requirements that lenders will look for include:

  • Steady income
  • Steady employment
  • Debt-to-income ratio of 43 percent, though some lenders will allow a ratio of up to 50 percent
  • At least 14 percent equity in your home

Summary

A home equity loan can allow you to use your home as funding for almost any purpose. You can elect to receive a lump sum amount for the entire equity in your home or choose a more flexible line of credit option. Interest rates are usually low, though closing costs are high and will increase the cost of the loan. There is an easy and straightforward process to qualify, but if you are not careful, you could risk losing your home to foreclosure. All the benefits and drawbacks should be considered carefully before you apply for a home equity loan.

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