You’ve owned your current home for more than 10 years, and properties in your neighborhood have gone way up. Meanwhile, there are some big ticket items you’d like to purchase. Though you’ve heard the term mentioned countless times before, you start wondering, What is a home equity loan exactly? Can you actually tap into your home’s current value and pay for anything you want?
The quick answer is yes. A home equity loan, sometimes called “a second mortgage,” lets you borrow against the equity you’ve built up on your house and use that loan to pay for anything you want. The second mortgage works exactly the same as your primary mortgage; the only difference is that home equity loans have shorter terms and slightly higher interest rates.
What are some common uses for home equity loans?
Because you receive the money as one lump sum, you can use a home equity loan for any purchase, including:
- College tuition and fees.
- Paying off high interest credit card debt (sometimes called “debt consolidation”).
- Home renovations.
- Medical bills.
- Purchasing a second home.
You don’t need to explain to the lender what you intend to do with the money. Once you qualify for the loan, it’s yours to spend as long as you continue to make the monthly payments on time.
What is the qualification process like?
In order to qualify for a home equity loan you must have over 20 percent equity in the property. Because banks won’t let you fall below the 20 percent threshold — also referred to as an 80 percent loan-to-value (LTV) ratio — you can only borrow amounts over 20 percent.
For instance, say your home’s value is $300,000, and your mortgage balance is $150,000. You have $150,000 dollars in equity, but in order to retain an 80 percent LTV ratio in the house, you can’t exceed a total of $240,000 (.80 x 300,000) in your combined mortgage loans. That leaves $90,000 in available home equity.
Some lenders use a more conservative LTV ratio — for instance, 75 percent — when they make loans. Keeping the LTV percentage lower than average may enable you to borrow at a more competitive rate or qualify for a loan if your debt-to-income ratio is high.
In order to quality for the best rate, you will need excellent credit, but most banks will let you take out a home equity loan with a score of 620 or more. Depending on the amount of loan requested, you may have to have a complete appraisal done. Sometimes, however, your lender will accept an automatic appraisal based on area comps.
How does a home equity loan differ from a home equity line of credit (HELOC)?
Although they both use your home equity as collateral, there are important differences between these loans. The home equity line of credit is a set amount of you can draw on as you need during a set period of time; in this sense, it functions like a credit card. If you find you don’t need the money after all, you don’t have use the line of credit.
Moreover, like credit cards, HELOCs have a variable rate that is tied to the prime rate set by the federal government. Home equity loans, on the other hand, are fixed rate loans. For a long time, HELOCs were a slightly better deal for homeowners because the prime rate was at rock bottom. But with the Federal Reserve now committed to raising the rate, interest rates on HELOCs could well rise above those for home equity loans, making the latter a better deal for people who need to borrow a set amount.
Should I take out a home equity loan of do a cash out refinance?
Another option for homeowners is to forego taking out a second mortgage altogether and simply refinance the entire mortgage loan, taking the accrued equity out and adjusting the new loan to a higher amount.
Under some conditions, cash out refinances are a better deal than home equity loans, particularly if you are able to refinance at a lower interest rate than the original loan. However, refinances typically require all of the same title work as primary mortgages, and you may have to pay up to 3 percent of the loan total in origination and other fees.
If you cannot get a cash out refinance at a lower rate, the home equity loan usually a better choice; however, there are always exceptions. It’s important to sit down and run a cost benefit analysis using all the available options to see which is the best choice for you.
Are there disadvantages to home equity loans?
There are disadvantages to incurring more debt, no matter how you do it. The danger of taking out a home equity loan to consolidate credit card debt, warns financial guru Dave Ramsey, is that you still have as much debt as ever even though you’ve managed to lower the interest rate. You might continue to spend unchecked because you’ve temporarily removed the sense of urgency that comes with high revolving debt.
Although Ramsey is right to caution Americans against using home equity loans to avoid financial responsibility, there are definitely times when taking out a second mortgage is not only a great option but also a good investment. Using them to pay for college, for instance, helps your children to enter the workforce without being saddled with debt. Using a home equity loan to finance a home renovation can dramatically increase the resale value of your home.
The bottom line is to use good judgment and common sense when thinking about tapping into your home’s equity. This asset can help you survive an emergency situation and, in some cases, increase your long-term net worth.
