Home equity loans are second mortgages secured by the borrower’s house and paid in one lump sum. Lenders will typically lend loans that are up to 85% of the borrower’s equity. Once the loan is disbursed, the borrower has to pay interest on the total amount. The interest rates start at about prime plus 2%. However, this can vary depending on factors such as credit history and employment.
What is a Home Equity Loan?
A home equity loan, which is a lump-sum loan with fixed rates and a fixed interest rate, is secured by the equity in the home of the borrower. A homeowner can borrow up to 85% of the equity in their home and repay it over five to thirty years, depending on the term.
Contrary to a home equity loan of credit (HELOC), the borrower gets the entire amount upfront and not just a portion. The borrower is responsible for the interest due to the immediate loan payout.
How do you calculate your home equity?
Lenders can use home equity to determine the amount of a loan they will extend to an applicant. Start with the appraised price of your home, and subtract any secured loans. This includes any mortgages, home equity lines of credit, as well as personal loans and other debts that are collateralized by the property.
Home Equity = Total Home Loans Secured by Home – Home Market Value
Lenders may require a formal appraisal of your home as part the loan underwriting process. To estimate your home’s market value, you can use websites like Zillow and Realtor.com.
Imagine a homeowner who owns a $450,000 house and has $350,000 owing on their mortgage. This owner will have $100,000 of equity if the house is not secured by any other loans. If their home is also used as collateral for the $50,000 personal loan that they used to create a pool, they will only have $50,000 equity [$450,000-$350,000-$50,000 = $50,000 equity].
How a home equity loan works
Home equity loans allow homeowners to borrow against their equity and get cash from their homes. Homeowners can apply for a home equity loan if they are faced with major expenses such as a wedding or kitchen remodel. The borrower will need to pay closing fees and costs of between 2% and 5 percent of the loan amount. These fees may be waived by some lenders.
The home equity loan is secured by the borrower’s home and therefore secondary to the mortgage. The home equity lender is therefore more at risk as it will not be paid until the first mortgage lender has paid.
The borrower receives the loan as a lump sum and must also pay interest. The loan is secured by the borrower’s home so the lender has the right to foreclose if the borrower does not make timely payments.
Home equity loan interest rates average around prime plus 2.2%. However, a borrower’s interest rate will ultimately be based on many factors such as income, employment, and credit history. Lenders consider the amount of equity the applicant has and the overall debt-to income ratio. This is the borrower’s monthly debt payments divided with their gross monthly income.
HELOC vs. Home Equity Loan
A home equity loan is a loan that a lender issues to the homeowner. The loan has a fixed interest rate and the homeowner pays the whole amount at once. The borrower will have to make monthly interest payments for the loan amount, which can be between 5 and 30 years. If you have a major home improvement project, a wedding, medical bill, or any other one-time expense, a home equity loan may be an option.
A HELOC allows homeowners to be approved for a specific amount of credit, rather than a lump sum. The borrower has the right to withdraw funds from the credit line at any time during the draw period, which typically lasts around 10 years. They are responsible for the interest on all withdrawals. HELOC interest rates are similar to home equity loans and typically hover around prime plus 2.2%. HELOC interest rates can fluctuate so borrower could be subject to higher interest should the prime rate go up.
The HELOC borrower has to make monthly payments for both principal and interest once the repayment period starts. Usually, this is over a 20 year period. HELOCs are a great choice for continuing costs such as college tuition, home renovations and other unpredictable expenses.
Maximum Home Equity Loan Borrowing Limits
Lenders consider many factors when determining the maximum home equity loan borrowing limit. This includes income, credit history, and equity. Lenders need to know the value of the collateral, which is the home, in order to secure home equity loans. Your lender may request a formal appraisal in order to determine the value of your home. Lenders limit loans to 85% of the applicant’s equity in a home, although this can change depending on other qualifications.
The homeowner in the above example had $100,000 worth of equity. If the homeowner meets all other requirements, they may be eligible to borrow as much as $85,000. The maximum home equity loan amount could be limited to $21,000 if the homeowner has less than $25,000 equity due to the personal loan.
Qualifying for a Home Equity Loan
Lenders have different requirements for home equity loans. However, most lenders require these minimum qualifications to be approved for a loan.
- A credit score of 620 and higher
- Home equity between 15% and 20%
- Evidence of income and employment that demonstrates the ability to repay the loan
- Ratio of debt-to-income below 43%
- Deduction in the tax on home equity loans
The Tax Cuts and Jobs Act 2017 has enacted federal tax law that allows homeowners to deduct interest on home equity loans. However, there are some limitations. First, the borrower must use his loan to “buy, construct, or substantially improve” the taxpayer’s home. However, the IRS clarified that regular home maintenance, such as repainting a house, does not qualify for the tax deduction.
The Tax Cuts and Jobs Act reduced the amount of home equity debt that is eligible for the deduction to $750,000 per household and $375,000 for married homeowners filing separate. Mortgages taken out prior to Dec. 16, 2017 are exempt from this new limit. You can still deduct interest up to $1,000,000 per household if you mortgaged your home prior to Dec. 16, 2017, or $500,000 if you are married filing separately.
Once you determine whether the home equity loan interest is deductible, you must also evaluate whether it’s more advantageous to take your itemized deductions–including the loan interest–or settle for the standard deduction. For married couples filing jointly, the standard deduction is $24,800. Single taxpayers can claim $12,400; married individuals can claim $18,650. This could be a good option for many taxpayers.
Alternatives to Home Equity Loans
If you have substantial equity in your house and need to pay for one-time expenses, a home equity loan might be an option. This type of loan is not recommended for people with poor credit histories or limited equity. Home equity loans are not the best option for long-term projects that have expenses spread over time. Consider a HELOC (as discussed previously) or one of the following alternatives before you commit to a home equity mortgage.
Personal Loan
Personal loans are available in secured and unsecured options. This makes them an attractive option for homeowners with little equity or those who don’t want to put up collateral. Unsecured personal loans have a higher interest than secured personal loans or home equity loans, but they are less risky as the lender cannot foreclose on the borrower’s home in case of default.
Cash-Out Refinance
Cash-out refinance allows homeowners to refinance their homes for more than what they owe. They also receive the additional amount in a lump sum. Because the refi acts like a first mortgage, it may be possible to get a lower interest rate. This option is available if you require assistance paying for large renovation projects, consolidating debt, or covering large expenses.
Credit Card
Credit cards are a form of credit that isn’t secured by your home or any other property, but is similar to a HELOC. Credit cards are a great option for those who don’t have enough equity to qualify for a HELOC, or cannot get a personal loan fast enough. Credit cards, however, are an unsecured form of debt. They typically have a higher interest rate and, depending on your credit, may not give you the spending power that you need.
Home Equity Loan Benefits
- Unsecured loans, such as personal loans or credit cards, have lower interest rates
- Fixed interest rates make it simpler for borrowers to budget monthly debt payments
- If you borrow money for home improvements, loan interest can be deducted.
Home Equity Loan Drawbacks
- Closing costs such as appraisal and underwriting fees can be borne by the borrower. These fees typically amount to between 2% and 5% of total loan amount.
- The entire amount of the loan is subject to interest
- This will reduce the equity in your home.
- It can be risky to end up owing more on your house than your fair market value if the property’s value in your area drops.
- If you decide to sell your house, you’ll need to pay off the remaining loan balance
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