SUMMARY: Understand how a home equity loan works and determine if it is the right choice for you.
If you, like many Americans, are looking to pay off credit card debt or other high-interest loans, or you need money for home renovations or repairs, a home equity loan may be your best bet. Not sure a home equity loan is the right choice for you? Here we discuss the pros and cons to help you along the way to your financial goals.
What is a Home Equity Loan?
A home equity loan, sometimes called a second mortgage, is a loan where the homeowner borrows against the equity available in their home. The amount is determined by calculating the difference between the value of your home and how much you owe on it. For example, if your home is worth $100,000 and you owe $75,000 on your mortgage, your home equity value is $25,000, or 25%. Most lenders require at least 20% in order to borrow against your home. It is important to note a home equity loan works just like a mortgage, so making monthly payments on time is essential.
Home Equity Loan vs. Home Equity Line of Credit
Many consumers think a home equity loan and a home equity line of credit (HELOC), are the same thing. This, however, is not the case. Where a home equity loan results in the borrower receiving a lump sum that must be repaid within a set period of time, a HELOC allows you access to a predetermined credit line for a set draw period. During this time you can borrow from this line of credit, but you are not committed to borrowing the entire amount.
Advantages of a Home Equity Loan
- There are no restrictions on what you can do with the money you borrow. Of course, that doesn’t mean you should borrow against your home to take a vacation. It is a good idea to use a home equity loan to build the value of your home or better your financial situation. Recommended uses for a home equity loan include starting a business, making home improvements, and paying off other high-interest debt. If you decide to use the money for home improvements, the interest you pay on the loan may be tax deductible.
- Home equity loans are generally easy to qualify for. As long as you have equity in your home, lenders don’t typically require the high credit scores they do for personal loans.
- Low, fixed interest rates. Home equity loans typically have fixed interest rates that are lower than other types of unsecured loans, making them an attractive option for many borrowers. The lower interest rate could save you lots of money over the life of the loan.
Disadvantages of a Home Equity Loan
- Your home is the collateral. This means if you fail to make timely payments on your home equity loan, you could lose your house. Make sure repayment according to the terms of the loan is within your budget before you commit.
- You pay closing costs. Just like a mortgage, a home equity loan typically comes with closing costs which range from 2-5% of the loan amount. You may be able to roll these fees into the loan amount, but make sure you take it into account when comparing your options.
- Selling or renting your home can be tricky. Lenders often do not allow you to rent out your property while you have an outstanding home equity loan. If you want to sell your home, you need to make sure to sell it for a high enough amount to cover the mortgage and the home equity loan.
Alternatives to a Home Equity Loan
As we mentioned earlier, HELOCs are another great way to tap into your home’s equity. Since they do not require you to borrow the full available amount, you could save a significant amount of money in interest with a HELOC.
A cash-out refinance remortgages your existing loan into a new one with lower interest rates which allows you to borrow more than the amount of your current mortgage balance and get a lump sum of cash upfront.
Personal loans allow you to borrow money without any collateral, but they typically have higher interest rates than secured loans.
If you are considering a home equity loan, a HELOC, or any other type of loan, contact TDECU today. Our experts will guide you to the best loan to meet your needs whether for debt consolidation, home renovation, starting a business, and more.