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A home equity loan is one of several types of mortgages that allows you to borrow against the value of your home. If you are interested in understanding whether this kind of mortgage is right for you -- and what the alternatives are -- this guide will help.
A home equity loan is a secured loan (a loan you get by putting up collateral). In this case, your home serves as collateral to guarantee the debt. Home equity loans are also called second mortgages. You must have equity in your home to apply with one of the best home equity loan lenders.
Home equity loans are paid back on a fixed schedule. You receive a lump sum of money when you borrow, and you repay it on a timeline predetermined with your lender. The repayment period is usually between five and 30 years.
You are eligible for a home equity loan only if you have equity in your home. That means your home is worth more than you owe on your current mortgage. If you have sufficient equity, you can apply for a mortgage of this type with a lender offering home equity loans.
Your lender will evaluate your financial credentials. The amount you can borrow and your interest rate is determined based on:
You will find out your interest rate and payoff time up front. Loans with higher rates are more expensive. A longer repayment time also makes your loan more expensive over time since you pay more interest, although each monthly payment is cheaper.
You can use the proceeds from a home equity loan for anything you'd like. The home guarantees the loan, and if you do not make payments, your home equity loan lender can foreclose on your home.
How much you can borrow with a home equity loan depends on how much you already owe and how much your home is worth.
Most mortgage lenders limit you to borrowing no more than 80% to 85% of what your home is worth. This includes your first mortgage and your home equity loan. Some lenders let you go up to 90%.
To understand this, take a simple example. Say your home is worth $100,000 and you owe $50,000. If you are allowed to borrow a total of 80% of your home's value across all loans, your maximum combined mortgage amount would be $80,000. Since you already owe $50,000, you would be able to take out a home equity loan for up to $30,000.
Home equity loans can be broadly divided into two types:
It's a good idea to check current mortgage interest rates for both fixed- and adjustable-rate home equity loans to decide which is right for you.
A variable-rate loan is much riskier because you take the chance of rates adjusting up -- especially if you're borrowing when rates are low. Be sure you know how high your rates could go before choosing a loan with a variable rate.
You can use the proceeds of a home equity loan for virtually anything. Many people use home equity loans for consolidating debt. That's because home equity loans usually have lower interest rates than many other types of loans.
Home equity loans can also be used for home improvement. Home equity loan interest may be tax deductible if you use the proceeds from the loan to buy, build, or substantially improve the home serving as collateral for the loan.
You take a risk when converting unsecured debt (a loan with no collateral), such as credit card debt, to secured debt. Be sure you can make the payments easily before putting your house on the line.
A three-day cancellation rule applies to home equity loans. This is an important consumer protection rule.
Under this rule, you have the right to cancel the transaction until midnight of the third business day after signing the credit contract. The clock starts when you receive a Truth in Lending disclosure providing the details of your loan. Creditors can't release the money from the loan until the third day has passed.
If you choose to cancel the contract, you must provide written notice to the creditor.
Home equity loans can come with high upfront fees. They are often called closing costs because they are paid at the time you close on the loan.
Home equity loan closing costs usually run between 2% and 5% of the amount borrowed. They include:
Some lenders allow you to roll these costs into your loan amount. This will mean you are borrowing more. If lenders advertise "no-closing-cost" loans, this is often what's happening. Some lenders also charge higher rates to cover closing costs in a "no-fee" loan, rather than adding the costs to your loan balance.
A home equity loan has some significant advantages, but also some disadvantages. Consider the pros and cons of a home equity loan when deciding if it is right for you.
Here are some of the biggest advantages of home equity loans:
If you know exactly how much you want to borrow and can qualify for an affordable home equity loan, this type of mortgage may be right for you.
There are also some downsides to home equity loans:
If you aren't sure how much you'll need to borrow or aren't confident that you'll be able to make monthly payments, you may want to steer clear of a home equity loan.
Here are some alternatives that also allow you to tap into home equity.
Deciding between a home equity loan or a home equity line of credit (HELOC) can be tricky because both allow you to take out a second loan to access equity in your home.
There are big differences between them though. Here's what they are:
Home Equity Loan | HELOC |
---|---|
You borrow a set amount | You borrow up to a certain amount (like a credit card); as you pay it back, you can draw from your credit line again |
You have a set repayment schedule and know total costs | Often don't have predictable costs or payoff schedules |
Fixed-rate loans are available | Most are variable-rate loans (some lenders offer fixed-rate loans) |
A cash-out refinance loan also allows you to tap into your equity. But it works differently than a home equity loan.
With a cash-out refinance loan, you don't get a second mortgage. Instead, you take out one new mortgage to pay off your existing home loan -- but you also borrow more than you currently owe so you end up with extra cash. For example, if you owe $50,000 on a $100,000 home, you could take out an $80,000 cash-out refi. You'd use $50,000 of the proceeds to repay your current loan and walk away with $30,000.
Cash-out refinance loans can have lower rates than home equity loans and could potentially save you money on your existing home loan. But they make sense only if you can reduce your current loan rate.
Many lenders offer home equity loans. Choosing a mortgage lender can be complicated as a result.
To make it easier, get quotes from several loan providers to find the best mortgage lenders for your situation. When comparing quotes, consider:
TIP
Improving your credit score before applying for a home equity loan can help you qualify for a better rate. You can improve your score by repaying debt, writing a goodwill letter to ask creditors to remove negative information from your credit report, or asking a loved one with a solid credit history to add you as an authorized user to one of their cards.
Here are some other questions we've answered:
Yes, a home equity loan is a type of mortgage. It's often referred to as a second mortgage. It is a secured loan guaranteed by the value of your home. As a result, if you do not pay a home equity loan, a lender can foreclose and take your home.
You can use a home equity loan for almost anything you'd like, like home repairs or debt consolidation.
Yes, home equity loans have closing costs. They are usually between 2% and 5% of the value of the loan. Some lenders advertise no-closing-cost loans, but you still end up paying the fees -- either because you are charged a higher interest rate or the fees are tacked onto your loan balance.
A home equity loan is a secured loan guaranteed by the value of your home, which serves as collateral. In some cases, interest on home equity loans is tax deductible if you use the proceeds to buy, build, or substantially improve the home and if you itemize on taxes.
Personal loans can be unsecured, which means there is no collateral guaranteeing the loan (although there are some secured personal loan options). Interest is usually higher on personal loans, but the initial fees are usually lower than closing costs on a home equity loan. Interest isn't tax deductible on personal loans.
Yes, a home equity loan must be paid off when you sell your home. This is why it's important not to take out too large of a home equity loan. If you end up owing more than the home is worth, it will be difficult to sell. You'd need to come up with the extra money to pay back your home equity loan lender.
Our Mortgages Expert
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