A home equity loan is a secured loan using the equity in your house as collateral for the loan. The equity in your house is equal to the value of your home minus what you owe on your mortgage. Home equity loans are similar to home equity lines of credit in that your home is used as collateral. However, loans typically provide one lump sum dollar amount at a fixed rate where as a line of credit acts more like a credit card with a variable interest rate and the ability to draw funds multiple times.
To qualify for a home equity loan you must be creditworthy and have equity in your home. Lenders will want to see a credit score in the very good to excellent range. If you qualified for the first mortgage you probably already have that taken care of. Additionally, lenders want assurance that you have enough income to cover the payments. They normally want to see your total monthly debt payments equal to no more than 36% of your total monthly income. In your total debt payments they will include your payments on your first mortgage and the loan, car payments, credit card payments, student loan payments, and anything else you owe money on.
Having equity in your home in order to take out a home equity loan may seem obvious. However, since home values have fallen so dramatically in recent years many people have lost a significant amount of equity in their homes and may not have the loan-to-value(LTV) ratios that lenders are looking for. The LTV ratio is the total amount of your mortgage balance plus the home equity loan divided by the appraised value of the home. Lenders generally want this to be 80% or less. During the housing bubble many lenders gave loans out that were 100% or more of the value of the home. This practice has generally stopped as many lenders have been burned by falling home prices.
There are serious pros and serious cons to consider with home equity loans. They are often a wise way to consolidate debts or finance a home renovation but can also lead to financial havoc if not evaluated properly.
Some of the benefits of a home equity loan are:
– You can use it towards a major purchase such as a car or home renovation and usually get a lower interest rate than you could find elsewhere.
– The interest paid on a home equity loan is usually tax deductible regardless of what you use the loan for.
Some serious considerations regarding home equity loans are:
– Just like your primary mortgage, if you default on a home equity loan your home can be taken from you.
– Many home equity loans are taking out with the assumption that housing values will always rise. This is why home equity loans were so popular during the housing bubble and lenders routinely gave out loans at 100%+ LTV. As we’ve seen in recent years this is simply not the case.
– Closing a home equity loan is just like closing a mortgage and will have similar closing costs that could add up fast. You’ll have to pay origination fees, appraisal fees, title fees, all over again. You must consider whether you can afford the fees and at least comparison shop to find the best deals.