A home equity loan is a type of second mortgage where you borrow money by leveraging the equity in your home. It allows you to borrow against your property’s value minus any outstanding mortgage payments. Generally speaking, banks will let you borrow 80% of the amount of equity you have in your home.
According to the property data provider company Black Knight, homeowners in the U.S. had $5.7 trillion in equity borrowing potential at the end of 2018!
Example: Suppose your house is worth $400,000 and you have an outstanding mortgage balance of $300,000. This means that there is $100,000 that you are able to borrow against.
This guide will break down the pros and cons of home equity loans and explain why you might consider taking one out.
Types Of Home Equity Loans
There are two types of home equity loans available: fixed-rate loans and home equity lines of credit (HELOC).
Fixed-rate home equity loans grant a lump sum payment to the borrower. It is generally repaid over a period of 5 to 15 years at a constant interest rate. Interest rates can vary from around 3% to 11% depending on the length of the loan.
Home Equity Lines of Credit (HELOC)
HELOCs have a revolving balance similar to a credit card. You can draw on the balance as needed, pay it back, and draw again for an amount of time set by the lender. The draw period is typically 5 to 10 years. A repayment period follows where draws are no longer permitted (typically 10 to 20 years). They usually have an interest rate that varies with the prime rate, although some lenders may switch to a fixed rate for the repayment period.
Advantages of Home Equity Loans
- Easy source of cash: Home equity loans allow you to access large amounts of money. As long as you have a sufficient amount of equity in your house to cover the loan, you can borrow a sizeable amount.
- Lower interest rates: You will likely pay lower interest rates than you would on a personal loan because a home equity loan is secured by your home.
- Tax advantages: According to the IRS, you are allowed to claim a tax deduction on the interest if you take out the loan to “buy, build, or improve your home.”
- Easier to qualify: Because the loan is secured by your home, home equity loans are typically easier to qualify for than personal loans.
Drawbacks of Home Equity Loans
- Closing costs: Unlike a personal loan, home equity loans will have closing costs that typically range from 2% to 5% of the loan.
- Risk of foreclosure: Since your home is collateral, you risk foreclosure on your home if you do not make payments.
- Unpredictable payments: HELOCs are typically adjustable-rate loans. This means payments can be unpredictable. If interest rates go up, so will your monthly payments.
- Frozen line of credit: Also with HELOCs, the lender may freeze or reduce your line of credit if your home value significantly declines or there is a change in your financial circumstances.
- Difficult for rentals to qualify: Most banks only offer HELOCs for a primary residence and not a rental property.
Why Take Out A Home Equity Loan?
People often take out home equity loans to cover large purchases such as a home remodel, an unexpected medical bill, or university tuition. If you are a responsible borrower with a steady source of income, home equity loans can be a valuable tool to cover major expenses that come up in life.
Consumers also commonly take them out to pay off credit card balances. It allows you to consolidate your debt with a single payment and likely have a lower interest rate.
Where Can You Get A Home Equity Loan?
You can apply for a home equity loan with several different types of lenders (banks, credit unions, loan originators, or by using the real estate superapp, Tellus) and compare costs. The lender will check your credit and may require an appraisal to assure the amount of equity you have. Generally, you will need to have at least 15% to 20% of equity and steady employment to qualify for a loan.
A home equity loan is a great way to take advantage of the equity you’ve built in your property and improve your overall financial picture.