You may have come across home equity loans in your search for a good loan option, or had it recommended to you by a friend or financial advisor. Home equity loans can be described as giant bags of cash with low-interest rates, but it’s important to understand the benefits, the risks, and the process of getting one (and paying it off) before you get too excited. In this article on home equity loans, The Balance warns that, “using your home to guarantee a loan comes with risks.”
That being said, home equity loans can be an excellent choice if you need to do any of the following:
- tackle home improvements or remodels
- pay for college
- make a real estate purchase such as another house
- consolidate other loans with high interest
What is a Home Equity Loan?
A home equity loan is a type of second home loan (the first being the amount you borrowed to purchase your house). There are two main types of home equity loans:
- “Lump sum” Home Equity Loan
- Line of Credit or Home Equity Line of Credit (HELOC)
The lump sum options means you get a set amount of cash out of your equity at one time and then pay it off in installments. You set the interest rate at the beginning.
You get approved for a maximum amount of loaned money, and then you borrow what you need. You can borrow multiple times if it’s below the maximum loan amount when it’s all added up. This line of credit is more flexible than a lump sum because you only pay interest on the amount you’ve borrowed. However, the lender can freeze your loan at any time, which could be trouble if they freeze it when you need it most. Also, the interest rates of this line of credit can change over time, for better or worse, rather than having one fixed interest rate for the entirety of the loan.
What You Need for a Home Equity Loan
- Your house needs to be worth more than what you still owe on it
- You need to have built up enough equity to qualify for approval
You may be thinking, “So far, so good.” Let’s look at the pros and cons of a home equity loan, so you can get a better idea of what you’re getting into.
The Perks of a Home Equity Loan
You don’t have to use a home equity loan for house-related expenses! You certainly can use it to remodel your kitchen or improve the overall value of your home, but there are other valid uses of home equity loans.
A home equity loan can give you a lot of financial assistance depending on how much your house is worth. It’s not quite like a cartoon animal running off into the sunset with a giant bag of money. You do have to pay it off, but it is a big chunk of financing that you can use on larger projects or purchases.
Home equity loans have lower interest rates than many other loan products.
Home equity loans are often available even if you have bad credit. Banks love home equity loans because they are secured by your home. If worse comes to worst and you can’t repay the loan, the bank gets your house. Typically, lenders don’t allow you to borrow more than 80% of the value of your home.
If you do use the loan for home improvements, you may be able to receive tax benefits. Some improvements, if they boost the overall value of your house, may be tax deductible.
The Risks of a Home Equity Loan
Home equity loans can be large, meaning there's a lot of money to pay back. If something happens and you aren’t able to pay the loan back on schedule, the bank will likely be able to foreclose on your house.
There are most often lender’s fees and closing costs. It may seem like a cheaper option at first because of the lower interest rate but consider your options with care to make sure you’re not better off using a higher-interest-rate loan with fewer fees.
Does a home equity loan still sound good? Here’s an overview of how you go about securing one.
Get your documents together first. There can be extensive paperwork required for a home equity loan, including proof of income and access to tax records. Double-check your credit scores and make sure your credit reports are correct. The lender or lenders will want to see all of this and maybe more.
Ask family members, friends, or local real estate agents about the best lenders (we happen to know a great one!). If you collect info from several different lenders, you can get estimates from each and compare interest rates, terms, and other fees. If you look at home equity offers online, remember that the best offers are for applicants with the highest credit scores and the highest income.
It may take several weeks for home equity loan money to be released to you, so don’t plan on an instant influx of cash, but a home equity loan can be a great choice if you’ve built up sufficient equity and your house is worth more than you still owe on it.