Home equity loans and lines of credit allow homeowners to use the equity they have in their homes to make a significant purchase, pay off debt, provide a financial cushion, and so much more.
The equity in your home is determined by subtracting the debt on your home from your home's current value. As home values rise and you make monthly mortgage payments, the equity you have in your home increases. You can use this as collateral to secure home equity loans or a home equity line of credit. Here's what you need to know about the two to make wise choices for your financial future.
What is a Home Equity Loan?
A home equity loan is a one-time lump sum loan based on the amount of your home's equity. The good news about this loan is that it can be used for anything from home renovations and improvements to funding a child's college, paying for a wedding, or even taking a dream vacation. Some people even use this money, which is available at a relatively low-interest rate, to pay off high-interest credit cards and consolidate other debt.
It's important to remember, however, that since your home's equity is being used to secure this loan, you are risking the loss of your home if you are unable, for some reason, to repay the loan. Home equity loans often have fixed interest rates and scheduled payments, so you know how much each payment will be, how many payments you must make, and how many payments remain before the loan is repaid in full.
What is a Home Equity Line of Credit?
A home equity line of credit also uses the equity you have in your home as security for the borrowed money. However, a line of credit is generated rather than a lump sum payment. This acts as a pool of money that you can come back to, time and again, when you need cash for various needs.
If you don't draw from the pool, then you owe nothing. However, once you take money from the line of credit, you must begin repayments at the current interest rate and continue making payments until the funds have been repaid. One great thing about a line of credit is that it allows you to access the equity in your home once, twice, or twenty times as long you do not exceed the total sum available to you.
The line of credit offers the flexibility you won't find in a loan and lower interest rates than you'll pay with most credit cards while serving as a revolving method of funding for emergencies and the occasional splurge. It is wise to consider that interest rates can rise and fall, sometimes significantly, so the variable interest rates associated with home equity lines of credit can become problematic if you aren't careful. Some home equity lines of credit also come with annual fees, prepayment penalties, and other small print items you must understand before committing to this option.
How Do Home Equity Loans and Lines of Credit Work?
You must apply for home equity loans and home equity lines of credit. Almost all home equity loans and lines of credit have Loan-to-value ratio requirements. So, you will need sufficient equity in your home to make these loans available.
The minimum LTV (loan-to-value) rate for a home equity loan will vary depending on the lender and the specific loan program. Lenders typically require a minimum LTV of 80% for a home equity loan.
This means that the loan cannot exceed 80% of the home's appraised value minus any outstanding mortgage balances.
However, some lenders may require a lower LTV, such as 70% or 75%, especially if the borrower has a lower credit score or other risk factors. Conversely, some lenders may allow for a higher LTV, such as 90%, for borrowers with solid credit and a history of responsible financial management.
It's essential to shop around and compare offers from multiple lenders to find a home equity loan with a favorable LTV and terms that meet your needs. Remember that a higher LTV can result in a higher interest rate and monthly payment and a greater risk of owing more on the loan than the home is worth if property values decline.
Another consideration is the housing market in your area. The best time to consider home equity loans or lines of credit is when home values are on the upswing, if not the peak. Your home needs to be valued above what you owe on the house for these loans to work. Banks will offer loans or lines of credit based on the equity you have in your home and your solid history of timely payments – among other criteria. You will likely need an appraisal of your home for its current value and need to pay closing costs and additional fees at the time of closing on a home equity loan.
Benefits
Both home equity options offer several benefits to consumers. Whether it is the fact that you can receive a single lump-sum payment or a line of credit that offers incredible flexibility or the fact that it is easier to qualify based on the equity you've created in your home, this is a viable option for many cash-strapped consumers. Additionally, home equity loans and lines of credit offer lower interest rates than personal loans, credit cards, and other options you might consider when financial needs arise.
Drawbacks
The biggest drawback, and one of the most important things to remember about home equity loans and lines of credit, is that they place your home at greater risk. Just as having a mortgage puts your home at risk of repossession if you can't repay the loan, these loans and lines of credit compound the risk. Now two creditors must be repaid promptly to prevent the loss of your home and your family's security.
Using Home Equity Responsibly
The key to responsibly using home equity is to avoid getting too deep with your borrowing. You never want to borrow more than you can comfortably repay and maintain a consistent standard of living, and it might be tempting to overspend or splurge a little too often. Set boundaries and make payments on time to avoid late fees and higher interest rates and to reduce your risks of losing your home.
Alternatives to Home Equity Loans and Lines of Credit
The most common alternatives to home equity loans and lines of credit include credit cards, which have considerably higher interest rates, and personal loans that may require additional collateral to secure the loan, charge higher interest rates, or place your finances at greater risk.