Homeowners frequently consider taking out a home equity loan when they need extra money for a significant expense. But what is a home equity loan, how does it work, and is it right for you?
This article will give you a detailed explanation of home equity loans, including information on their advantages and drawbacks.
A home equity loan allows you to borrow against the value of your home.
What is a Home Equity Loan?
A home equity loan is a loan that lets you borrow against the value of your property. Equity is the gap between your home’s market value and the remaining debt on your mortgage. For instance, if your house is worth $300,000 and your mortgage balance is still $200,000, you have $100,000 in equity.
With a home equity loan, you can take out a one-time loan based on the value of your house. Usually, the loan is repaid over a set time with fixed monthly payments. Because your house secures a home equity loan, the interest rate is typically lower than that of other consumer loans.
How Does a Home Equity Loan Work?
You must first apply to a lender to obtain a home equity loan. The lender will determine your loan eligibility based on your credit score, income, and other financial variables. If given the go-ahead, the lender will appraise your house to decide its market value and how much equity you have.
Following that, the lender will make you a loan offer based on a portion of the equity in your house. Depending on the lender, this proportion can be between 80% and 90% of the value of your home, less the total owed on your mortgage.
The lender will give you the money if you accept the loan offer. After that, you will repay the loan with fixed monthly installments over a predetermined period, typically between 5 and 30 years. You will also be responsible for paying interest on the loan, which is normally deductible from your taxes.
What is a Home Equity Loan Used For?
Home equity loans frequently cover costs like home renovations, medical expenses, or college tuition.
- Home improvements: Many homeowners use a home equity loan to pay for home improvement tasks like a new roof, kitchen remodel, or bathroom remodel. If you want to invest in your home, a home equity loan could be a good choice because home improvements can raise the value of your home.
- Medical costs: Medical bills can add up quickly, and a home equity loan could be a way to pay for expensive medical bills or elective surgeries that aren’t covered by insurance.
- College tuition and other educational costs: A home equity loan is frequently used by families to cover college tuition and other educational costs. Before taking out a home equity loan, it’s crucial to consider alternative financing choices, such as federal student loans or scholarships.
- Debt consolidation: If you want to consolidate high-interest loans or credit card debt, a home equity loan can be an excellent alternative. By putting all of your debts into one, you might be able to lower your overall interest rate and save money on interest payments over time.
Home Equity Loan vs. HELOC
| Home Equity Loan | Home Equity Line of Credit (HELOC) | |
| Definition | A loan that provides a lump sum of money upfront, which is paid back over time with a fixed interest rate | HELOC is a line of credit that allows you to borrow money as needed, up to a predetermined credit limit, with a variable interest rate |
| Repayment | Fixed payments over a set period of time | Monthly payments that vary based on the amount borrowed and the current interest rate |
| Interest rate | Fixed interest rate | Variable interest rate |
| Borrowing limit | Generally up to 80% of your home’s value minus any outstanding mortgage balance | Generally up to 85% of your home’s value minus any outstanding mortgage balance |
| Access to funds | One-time lump sum payment | As needed, up to the credit limit, during a specified draw period |
| Fees and costs | Application fees, closing costs, and appraisal fees | Application fees, closing costs, appraisal fees, and annual maintenance fees |
| Risks | If payments are not made, the borrower risks foreclosure | If payments are not made, the borrower risks foreclosure |
| Best for | Borrowers who need a lump sum of money for a specific purpose, such as home renovations or debt consolidation | Borrowers who need ongoing access to funds over time, such as for a home improvement project with multiple phases |
| Examples of lenders | Wells Fargo, Chase, Bank of America | U.S. Bank, TD Bank, PNC Bank |
Pros and Cons of Home Equity Funds
Pros:
- Lower interest rates: As this loan is secured by your house rather than other loans like personal loans or credit cards, they frequently have lower interest rates.
- Large loan amounts: You might be able to take out a home equity loan to borrow a sizable quantity of money, depending on the value of your house and your equity.
- Flexible use of funds: Home equity loans can be used for various things, such as big purchases, consolidating debt, and improving your home.
- Tax advantages: The interest you pay on a home equity loan may be tax deductible, which could help you pay less in taxes overall.
Cons:
- Risk of foreclosure: Because your house backs the home equity loan, if you don’t make your payments, your house could be taken away.
- Fees and closing expenses: Home equity loans, like other loans, have fees and closing costs that can quickly mount up and raise the overall cost of the loan.
- Debt accumulation: Getting a home equity loan can result in more debt that could be challenging to pay off in the long run. Before applying for a loan, you must be sure you can afford to make the payments on it.
- Changes in interest rates: If you have a home equity loan with a variable interest rate, your monthly payments may change over time. This can make it hard to plan your budget and future costs.
Key Points
- A home equity loan is a loan that allows you to borrow against the value of your property.
- Because your house secures it, home equity loans often have lower interest rates than other loan types.
- A home equity loan provides a large sum of cash up front that is repaid over time at a fixed interest rate.
- Home equity loans are often used to pay for home improvements, pay off debt, and other big expenses.
- Borrowers who want a sizable sum of money and like the predictability of a fixed interest rate and payments may find home equity loans to be an intelligent alternative.
