How to Use Home Equity Loans and How it Works
If you’re reading this, then you certainly have questions about How to use home equity loans and how it works. Building equity is one of the most desirable perks of homeownership. It can be used to secure a second mortgage and generate low cost funds for the homeowner either as a one time loan or a hone equity line of credit(HELOC). As with most things on earth it comes with its pros and cons so lets get into the details.
In this article we talk about:
- How to use home equity loans and how it works
- Basics of home equity
- Eligibility for home equity loans
- How to build home equity
Home equity loans may make sense for people who want to take advantage of low interest rates and long repayment terms. However, before you commit to using your home equity, consider both the benefits and the drawbacks.
Basics of Equity Loan
Home equity loans and HELOCS use the equity in your home that is, the difference between your home’s value and your mortgage balance—as collateral. As the loans are secured against the equity value of your home, home equity loans offer extremely competitive interest rates usually close to those of first mortgages. Compared with unsecured borrowing sources, such as credit cards, you’ll be paying less in financing fees for the same loan amount.
However, there’s a downside to using your home as collateral. Home equity lenders place a second lien on your home, giving them rights to your home along with the first mortgage lien if you fail to make payments. The more you borrow against your house or condo, the more you’re putting yourself at risk.
Equity Loan Eligibility
Banks underwrite second mortgages much like other home loans. They each have guidelines that dictate how much they can lend based on the value of your property and your creditworthiness. This is expressed in a combined loan-to-value (CLTV) ratio.
Let’s suppose you’re working with a bank that offers a maximum CLTV ratio of 80%, and your home is worth $300,000. If you currently owe $150,000 on your first mortgage, you may qualify to borrow an additional $90,000 in the form of a home equity loan or HELOC ($300,000 x 0.80 = $240,000 – $150,000 = $90,000).
Like other mortgages, your eligibility for a loan and interest rate depends on your employment history, income, and credit score. The higher your score, the lower the risk you pose of defaulting on your loan, and the lower your rate.
How to Use Home Equity Loans
A home equity loan comes as a lump sum of cash. It’s an option if you need the money for a one-time expense, such as a wedding or a kitchen renovation. These loans usually offer fixed rates, so you know precisely what your monthly payments will be when you take one out.1
Home equity loans usually aren’t the answer if you only need a small infusion of cash. Though some lenders will extend loans for $10,000, many won’t give you one for less than $35,000. What’s more, you have to pay many of the same closing costs associated with a first mortgage, such as loan-processing fees, organization fees, appraisal fees, and recording fees.1
Lenders may require you to pay “points” that is, prepaid interest—at closing time. Each point is equal to 1% of the loan value.2 So on a $100,000 loan, one point would cost you $1,000.
Points lower your interest rate, which might actually help you in the long run. Still, if you’re thinking about paying off the loan early, that upfront interest doesn’t exactly work in your favor. If you think that might be the case, you can often negotiate for fewer or even no points with your lender.
Home equity is the portion of your home that you’ve paid off — your stake in the property, as opposed to the lender’s. For many homeowners, home equity is their most valuable asset. The best part of home equity is that it often increases without you having to do anything more than making your regular monthly mortgage payment.
How Home Equity Works
Whether you’re looking to free up cash for a home renovation or find ways to consolidate debt, borrowing against the value of your home could be a good option. While you pay off your home, you build equity that you can later use for home equity loans or home equity lines of credit (HELOCs).
Because you can use equity for loans or tap into it when selling your home, it’s a great financial tool. The bigger your down payment and the more you pay toward your mortgage, the greater chance you have at increasing your total equity.
If you’re considering using your home equity, keep the following in mind:
- Build your equity. You can increase the equity in your home by making payments on your mortgage or making home improvements that increase your property’s value.
- Calculate your equity. Subtract your mortgage balance from your home’s current market value. To get an estimate of your home’s current value, use an online home price estimator tool like Zillow’s Zestimate. For example, if the estimator says that your home is worth $250,000 and you still owe $150,000, the estimated equity in your home would equal $100,000.
- Consider the benefits and drawbacks of a home equity loan. Using home equity to fund emergency expenses or consolidate debt isn’t the right choice for everyone. Before applying for a home equity loan, consider the risks of using your home as collateral — for instance, the risk of losing your home if you default — and look into personal loan options or other debt consolidation loan alternatives.
- Learn if you qualify. Lenders typically require 20 percent equity, a minimum credit score in the mid-600s and a debt-to-income ratio below 43 percent before you can borrow from your home equity.
Types of home equity loans
There are two types of home equity products, which differ in how you receive the cash and how you repay funds.
Home equity loans
A home equity loan is a second mortgage, meaning a debt that is secured by your property. When you get a home equity loan, your lender will pay out a single lump sum. Once you’ve received your loan, you start repaying it right away at a fixed interest rate. That means you’ll pay a set amount every month for the term of the loan, whether it’s five years or 15 years. This option is ideal if you have a large, immediate expense. It also comes with the stability of predictable monthly payments.
Home equity lines of credit (HELOCs)
A home equity line of credit, or HELOC, works like a credit card. You can withdraw as much as you want up to the credit limit during an initial draw period that is usually up to 10 years. As you pay down the HELOC principal, the credit revolves and you can use it again. This gives you flexibility to get money as you need it.
You can opt for interest-only payments or a combination of interest and principal payments. The latter helps you pay off the loan more quickly.
Most HELOCs come with variable rates, meaning your monthly payment can go up or down over the loan’s lifetime. Some lenders offer fixed-rate HELOCs, but these tend to have higher initial interest rates and sometimes an additional fee.
After the draw period, the remaining interest and the principal balance are due. Repayment periods tend to be from 10 to 20 years. The interest on a HELOC that is used for a substantial home improvement project may be tax-deductible
How do I build home equity?
Because home equity is the difference between your home’s current market value and your mortgage balance, your home equity can increase in a few circumstances:
- When you make mortgage payments. The easiest way to increase your home’s equity is by reducing the outstanding balance on your mortgage. Every month when you make your regular mortgage payment, you are paying down your mortgage balance and increasing your home equity. You can also make additional mortgage principal payments to build your equity even faster.
- When you make home improvements that increase your property’s value. Even if your mortgage principal balance remains the same, increasing the value of your home also increases your home equity. Just keep in mind that some home renovations add more value than others, research before starting a renovation project if your goal is to increase home equity.
- When the property value rises. Often (but not always), property values rise over time. This is called appreciation, and it can be another way for you to build your home equity. Because your property increasing in value depends on several factors, such as your location and the economy, there’s no way to tell how long you’ll have to stay in your home to expect a decent rise in value. However, looking at the historical price data of homes in your area may give you some insight as to whether home prices have been trending upward or downward.
- When you make a large down payment. Putting down a larger down payment can also increase the equity in your home. For example, if you put down 20 percent on your home instead of 10 percent, you’d have more equity. Doing so could also allow you to tap your home equity faster because lenders usually require you to have 20 percent equity in your home.
This article hopefully answers all your questions about How to Use Home Equity Loans and How it Works feel free to read again as it is simple and well detailed.
Home equity can be a great source of value for homeowners to access cash for renovations, large purchases, or alternative debt repayment.. But you should do so with care and shop around with multiple lenders before signing up.