When you need access to money for reasons other than purchasing a home or a vehicle, you may find you don’t have many options apart from a personal loan. But one of the options you may not have considered is a home equity loan.
After purchasing a home, you will start paying down the amount you owe and, at the same time, the value of the house will (hopefully) rise. This means that you will start to accrue equity, which is essentially like trapped money that could be put toward other goals, like a home improvement project or paying off high-interest debt.
Some people opt to open a home equity line of credit or a home equity loan, but taking out these types of loans involves paying more interest and comes with its own risks. Before taking out a home equity loan, you should consider the following points:
1. Home equity loans are not the same as home equity lines of credit.
Many people talk about home equity lines of credit and home equity loans as if they are equivalent, but they actually represent two distinct borrowing structures. A home equity loan works much like a traditional mortgage, with a set amount borrowed for a specified period of time. Usually, the loan comes with a fixed interest rate.
A home equity line of credit, on the other hand, makes it possible to borrow money up to a certain amount at a variable interest rate. You are approved for a certain amount, but you do not have to use it all at once. In some respects, this account functions like a credit card, but with a very low interest rate since your home acts as collateral. You pay the money back over time and may be able to renew the line of credit once it expires. However, interest rates can rise. Also, you will need to pay back whatever balance is left once the line expires.
2. Loans depend on the amount of equity accrued in a home.
Not everyone will qualify for a loan based on the equity they have. Banks look at the home as collateral, so they want to make sure that the house can be sold for a price high enough to pay off the loan should something happen during repayment. Several factors will influence how much money someone can borrow, including the current state of the real estate market. When property values start to fall, banks will become less likely to grant a loan since there is a chance that the collateral may not cover the loan. Banks will consider the amount still owed on a mortgage and the new loan in comparison to the predicted value of the home. In general, banks will not issue a new loan unless the debt-to-value ratio is 80 percent or less, although some organizations will be more lenient with borrowers who have excellent credit. However, these loans will often have a higher interest rate.
3. Home equity loans have higher interest rates than a mortgage.
While home equity loans function much like mortgages, they usually come with higher interest rates. The reason that the interest is higher is that these loans are essentially second mortgages, meaning that the primary mortgage lender has first claim to the house in the event of foreclosure. Thus, if the home sells for less than the combined balances, the mortgage gets paid off first and the equity lender would be short-changed. This higher risk justifies the higher interest rate. The interest rate for a home equity loan is generally about 1.5 percent to 2 percent higher than a fixed-rate mortgage, while a home equity line of credit often has higher rates than a loan.
4. Borrowers accept some risks with home equity loans.
The risks involved with a home equity loan do not always make it a wise course of action. In general, using a home equity loan to pay off credit card debt, however, could prove to be a good idea since it can save significantly on interest.
However, if the property starts to lose value, homeowners may find themselves underwater, meaning that they owe more than the home is actually worth. If this happens, you would get stuck with the property, as you would not be able to sell it without bringing additional cash to the table; you will first need to pay off the loans in full as there is no longer collateral.
The other major risk is losing the home altogether. If you do not plan your budgets adequately and default on the home equity loan, the house will get foreclosed on even if the primary mortgage is paid. Before borrowing, you need to verify that you can make payments for the life of the loan and accept the consequences should something unexpected happen.