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Home Equity Loan 101: How Does It Work, Benefits, Risks And Alternatives

Home equity loan enable you to use the equity that you’ve built into your mortgage. But is it the right thing to do? Here's how it works, the benefits and risks, eligibility conditions and a couple of alternatives.
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Home Equity Loan 101: How Does It Work, Benefits, Risks And Alternatives

If you’ve ever had a large expense you know how difficult it can be to come up with the money. No matter what that big project is, it can be the lack of funds that makes it difficult for out to achieve what you want. Even worse, you may have financing options, but if they offer high interest or short terms you might be just as out of luck as before.

On the other hand, if you’ve been building up equity on your home it’s entirely possible that you could opt for a home equity loan and those are definitely going to make it easier for you to get that new project done.

What is a Home Equity Loan?

Let’s start with what a home equity loan is. It’s a way that you can use the equity that you’ve built into your mortgage as a way to finance the large projects that you want to do. What’s great is you can use the money for pretty much anything you want and you may even be able to deduct the interest on your taxes (but your advisor will know more). That makes them great for just about anyone, and you can usually borrow up to 85% of the value of your home (minus whatever you still owe, of course).

Now, in order to determine what the equity on your home actually is you take the amount that your house is worth and you subtract the amount that you still owe. If you have a $400,000 house and you still owe $200,000 on your mortgage that means you have $200,000 in equity. Then you can get cash for that amount with a loan that’s secured by your home.

Basically, that home equity loan is a second mortgage on your house. You don’t have to worry about getting a new first mortgage or refinancing or anything like that, which keeps the costs down for you. Instead, you get  a second mortgage that may not have quite as good of rates as the original loan (which you still have) but it’s better than your other options.

How a Home Equity Loan Works

If you’re looking to take out a home equity loan you’re going to have two different options to choose from.

The first option is that you can take a large lump sum of cash out as your loan. You then pay back the money in monthly payments and you get set with an interest rate right at the start of the loan. That interest rate then stays fixed over the entire life of your loan and each time you make a payment you’re going to lower the amount due. It’s called an amortizing loan, but it’s not your only option.

A HELOC is the other option. This is a home equity line of credit and gives you a total amount that you can borrow, but lets you choose what you want to borrow within that amount. In fact, you could borrow some money now and then go back and borrow again later. You also get the option to make smaller payments when you first start out and increase those payments as you go along.

This type of loan is going to give you the ability to control how much you take out and it’s going to help you control how much you’re paying in interest too, because you only pay interest on the amount you actually took, not the amount you’re approved for.

Of course, a lender could decide to freeze your line of credit at any time and that means you wouldn’t be able to take out any more. They tend to happen randomly too, so you might find yourself frozen out when you really want the money. Plus, these types of loans usually have variable interest, meaning you never know what your rate is going to be.

When you take the loan you’re going to get a lump sum of money and you can use it for anything you want. Whether that’s consolidating debt, paying for renovations on your home or anything at all. The key is to make sure that you start paying right away and that you can get a fixed interest rate if at all possible. That’s going to give you set payments and a stable payoff date.

The Biggest Benefits with a Home Equity Loan

  • Low Rates – One of the biggest benefits here is that you’re going to have a lower interest rate than you’d normally get with other types of loans or even credit cards. That means you’re going to have a lower cost to borrow the money, though you’ll generally have to pay closing costs.
  • Large Amounts Available – You can usually get a lump sum of money and you’ll be able to use them immediately for whatever you want. Whether that’s a purchase, consolidating debt or anything else. It’s entirely up to you.
  • No Costs Up Front – You don’t have to worry about closing costs or origination fees or application fees when you’re applying for this type of loan, which is definitely going to be a great aspect and it’s going to save you some extra money.

Home Equity Loan Eligibility

Okay, but what are you going to do to make sure you qualify for this type of loan:

  • Home Equity – The first thing you need is actual equity in your home. You need to have paid something in and have paid off some of the value of your house. Also, you’re not going to get all of the money that you’ve paid in back. The bank is going to determine just how much you can take, which is usually a maximum of 80% of your home value (minus whatever you still owe).
  • Great Credit – These types of loans are generally going to go to people who have a good or great credit score. You should be at least at a 640 or you could struggle to get an equity loan. If you want a HELOC you’re going to need a higher score and if you want to get the best interest rates you’ll want at least a 760. Of course, it’s all going to depend on your credit report and the specific company that you go with.
  • Loan-to-Value Ratio – Your loan-to-value ratio is how much you want compared to how much you owe and divided by the amount that your home is worth. You generally need to have a maximum of 80%, which means you would have 20% equity in your home already.

The Biggest Risks

Now, the biggest problem for people who do get this type of loan is using it improperly. If you’re the type of person who struggles with spending and borrowing and who always seems to be getting deeper and deeper into debt then this is something extremely dangerous for you. Lenders call this reloading and it means taking out a loan that will pay off the debt you have but give you more credit. That generally results in you spending even more and getting in even bigger trouble in the long run.

If you continue reloading you’ll find that you get even higher and higher home-equity loans and that you’re soon owing a whole lot more on your house and everywhere else. If you take out more than your house is worth you’re even going to add on more fees and expenses.

Important: Know Why You’re Borrowing

The most important thing that you should do is make sure that you’re getting a loan only if you really need it. If you need to consolidate debt, for example, you can save a lot of money with this type of loan because it gets rid of some of the high interest. If you’re going to improve your home and sell it in the future you’re going to be making a good investment. For some it even makes sense to use these loans to pay for tuition. On the other hand, buying items that you don’t need or paying for a vacation is definitely not a good idea with this type of loan.

Make sure that you realize your home is on the chopping block when it comes to these loans. If you don’t make the payments and pay back what you’re supposed to you can actually lose your home. That’s why it’s important to stay away from these loans if possible.

Home Equity Loans – Tips to Follow

Get Some Quotes – Before you decide to go with just anyone for your loan you want to get a few different quotes. Go to at least a few different lenders to get an idea of what they’re going to offer and see where you can get the best deal. Also, don’t be afraid to negotiate the initial costs, interest rates and any of the other terms.

Get a Better Score – You want to make sure that you have a good credit score before you even get started or you could end up getting denied. That means you want to make sure you’re getting a copy of your credit report every year and that you’re paying attention to what it says about you. Then, work on improving your credit score as much as possible and get rid of any inaccuracies before you ever apply. This will make it more likely that you’ll get approved when you do apply.

Know What You’re Trying to Do – If you know what you’re planning to do with the money you’re going to have a better idea of just how you should go about getting it. For example, a home equity loan is generally better for those who have long-term financial needs. A HELOC is generally for those with shorter-term financial needs.

Know What You Need – Before you actually apply for a loan you want to make sure you know how much money you actually need. How much is the project or service that you’re getting done going to cost? You want to know the total so you can take out only what you need for your loan. That way you’re not borrowing more than necessary.

Know Your Equity – Before you even go to your lender to apply for a loan it’s important for you to know that you have enough equity. That way you can save your time and the time of the lender as well. If you can do the math and know you don’t have at least 20% equity built up or that you’re going to want more than 80% of your home’s value you’re not likely to get the loan.

Know What the Future Holds – If you’re planning to sell your house soon you’re going to need to pay off your mortgage and your loan at that time. That means you want to know the future plans (or at least the near future plans) before you jump into anything. If you have a longer term you can make your payments lower. If you have a shorter term you’ll need to pay more.

Alternatives to Home Equity Loans

If you would like to avoid using your home equity, there are a couple of alternatives you can consider instead:

1. Refinance for Cash

If you do a cash-out refinance you’re going to have the option to get cash from the equity in your home and a little extra as well. With this type of process, you’re going to refinance your house and you’re going to add the amount of money that you’re borrowing onto the mortgage.

Instead of getting a traditional refinance where you’ll end up with a loan that’s the same total as the one you had, this mortgage is going to be larger than what you had before. You may be able to get a good amount of money without the high interest rates if your new interest on the mortgage isn’t going to go up.

2. Credit Cards

Generally, a credit card is going to be really easy, but it’s also going to be really expensive. You can usually buy whatever you want with the card and then you can pay it off over time, however you want. But you could end up with the interest that’s over 20%, especially if you have a bad credit history and that’s going to be more expensive than any loan you’ll get.

If you’re looking for money quickly this might be the way to go, but if you’re going to be needing that money for a few months it may not be such a good idea. That’s because you’re going to have high interest and you’re going to end up paying a whole lot more in the long run.

3. Personal Loan

There are a couple of different ways you can use personal loans, either secured or unsecured. If you have good financial standing and credit then you may be able to get an unsecured loan, which means you just give your word that you’ll pay the money back at the agreed rate and over the agreed time period.

When it comes to this type of loan you’re not going to have a tax-deductible aspect but you’re likely going to be able to get a lower interest rate, which might just be worth it compared to that credit card. It might be a little higher than a home equity loan though, which can be a bit of a drawback overall.

When you get a secured loan it means that you’re giving the bank or institution some form of collateral that says you’re going to keep making the payments as agreed. This might be your CD’s, stocks, a boat or a vehicle. It’s generally going to mean an even lower interest rate than the secured loan, but if you default on something you’re going to lose whatever the collateral was.

These loans do not offer tax-deductible features either, unless you’re using the money for certain types of expenses, including home improvements.