Home Equity Loans: The Pros and Cons

Home Ownership Man playing soccer with child in front of his home

At some point in your financial journey as a homeowner, you will eventually own a higher percentage of your home’s total value than you owe. Once you’ve earned a certain percentage of equity in your home, you may be eligible to take out a home equity loan. Home equity loans are a great way to quickly access a substantial amount of cash, and are typically used for specific purposes, like financing major home improvements that will increase your property value, funding investments in other properties, or consolidating debt.

However, taking out a home equity loan can also be risky. Should you fail to meet your monthly payments, you could risk losing your home. That’s why it’s crucial to take the time to understand how home equity loans work, and whether or not you’re financially equipped to take one out.

What Is a Home Equity Loan?

Family discussing loans with a lender in their kitchen

A home equity loan is a type of loan you take out against your own home, meaning your property is used as collateral. To be eligible for a home equity loan, your home needs to be worth more than you owe. When you’ve reached that point, you can borrow against a percentage of your total equity. In principle, the more equity you own, the more you can borrow. Because home equity loans are secured through your home, they are easier to qualify for than other types of loans.

Home equity loans come in two forms: They can be taken out as a lump sum amount, or as a home equity line of credit (HELOC).

Lump Sum

If you decide to take out your home equity loan as a lump sum amount, you receive the total agreed upon amount of money all at once. Borrowing a lump sum may come with a fixed interest rate and level monthly payments that whittle down the principal and interest together over the course of the repayment term. If you stick to your repayment timeline, both your accrued interest and principal will be completely paid off by your last payment.

HELOC

Taking out a home equity line of credit means you are approved for a maximum amount that you can borrow as needed. Payments are more flexible in that you can opt to pay smaller amounts early on in the repayment term, but this can offset payments in the future, making the loan more difficult to pay back.

How Does a Home Equity Loan Work?

Illustration of the home equity loan process in three steps

To get a home equity loan, you must be approved by a lender, be it a bank or credit union. Lenders will assess your eligibility based on several details, like how much equity you own, your home’s appraised value, your credit score, your income record and your employment status. Lenders take these factors into account to determine how much money they can reasonably loan you without it being too great a risk on their end. Once approved, you usually receive your money within a few of your loan closing.

Also known as a “second mortgage,” home equity loans are available as fixed- or adjustable-rate loans. A fixed-rate loan has a consistent interest rate throughout the life of the loan, meaning your payments will remain the same until the loan is paid in full. Adjustable-rate loans usually come with a fixed interest rate for the first year or so after the loan is issued. After this point, the interest rate will be readjusted annually, either increasing or decreasing your monthly payment.

As you might imagine, there are some pros and cons to consider before you decide to take out a home equity loan:

The Pros

  • Fixed interest rate: Home equity loans come with a fixed interest rate, meaning you will have the same monthly payment until the loan is paid back.
  • Lower borrowing cost: Interest rates are generally lower for home equity loans than credit cards or personal loans because you borrow against your home.
  • Lump sum amount: The total amount of the loan is paid out to you in one payment. You can spend this money however you see fit.

The Cons

  • Lower equity: When you use a percentage of your equity to secure a loan, it is subtracted from the equity you’ve accumulated. In other words, you no longer own it.
  • Closing costs: Home equity loans may come with extra fees and a closing cost, which may or may not be rolled into your monthly payments.
  • Property as collateral: Equity is used as collateral, meaning if you default on your payment, the lender can foreclose your home.

How to Get a Home Equity Loan

Illustration of how to get home equity loan approved in four steps

To be approved for a home equity loan, you must first qualify for one. Below is a checklist of what you need in order to qualify:

  • Find your home’s appraised value. The price you bought your home for is its market value, but lenders need to know your home’s appraised value. You can hire a professional appraiser to determine how much your home is worth, but bear in mind that it is costly and will be required as part of the loan approval process when you apply.
  • Determine how much equity you have. To get a rough estimate of your home’s equity, you need to calculate your loan-to-value ratio (LTV). You can find your LTV by dividing your current mortgage balance by your appraised value and converting that number to a percentage.
  • Calculate your Debt-to-Income (DTI) ratio. Lenders consider your DTI to see if you can handle a home equity loan payment on top of your current financial obligations. Your DTI ratio should ideally be below 43 percent. To calculate your DTI, add up all of your monthly expenses, divide it by your gross monthly income, and convert that number to a percentage.
  • Have a decent credit score. You should ideally have a credit score of 620 or higher.

If you meet these qualifications, then you can start shopping for lenders. Here are a few things to do when considering a lender:

  • Check their application requirements. It’s wise to only apply to lenders that you think are likely to approve you. Otherwise, you may end up paying for application fees and spending more than you should.
  • Find a lender with the right loan limits. Banks have a minimum loan amount and a maximum loan-to-value amount they offer, so research what banks are within your range.
  • Look for a reasonable interest rate. The cost of a loan’s interest is determined by its annual percentage rate (APR). The lower the APR, the better a deal it is for you.
  • Consider additional fees. Different lenders may have fees you need to pay in addition to your monthly payment. Research what fees are included, and when you are expected to pay them within the repayment term.

Taking out a home equity loan may be a great way to help you make some financial headway, be it paying off a substantial debt with a high interest rate or simply reinvesting the money into your home. Whatever you decide, be careful to plan ahead so that you can pay back the loan in the future and avoid the risk of losing your home.

Sources: Investopedia | Consumer Finance

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