What is a home equity loan?
A home equity loan, also known as a home equity loan, a home equity installment loan or a second mortgage, is a type of consumer debt. It allows owners to borrow against their assets in the residence. The loan amount is based on the difference between the current market value of the home and the homeowner’s mortgage balance owed.
How a home equity loan works
Essentially, a home equity loan is a mortgage. Your home equity is used as collateral by the lender. The amount a homeowner is allowed to borrow will be based in part on a combined loan-to-value ratio (CLTV) of 80% to 90% of the appraised value of the home. Of course, the amount of the loan, as well as the interest rate charged, will also depend on the borrower’s credit rating and payment history. Traditional home equity loans have repayment terms, just like conventional conventional mortgages. You make regular and fixed payments covering both principal and interest. As with any mortgage, if the loan is not paid off, the house could be sold to pay off the remaining debt.
A home equity loan is a good way to convert the equity you have accumulated in your home into cash. But always remember that you are putting your home in danger.
Tax Considerations for Home Equity Loans
Home equity loans exploded in popularity after the 1986 Tax Reform Act because they allowed consumers to bypass one of its main provisions – the elimination of interest deductions on most consumer purchases. The law left one big exception: interest on debt service based on residence. However, the 2020 Tax Reduction and Jobs Act suspended the deduction for interest paid on home equity loans and lines of credit until 2026, unless, according to the IRS, “they are used to buy, build or significantly improve the taxpayer’s home that secures the loan. »Interest on a home equity loan used to consolidate debts or pay a child’s school fees is not tax deductible.
Home Equity Loans and Home Equity Lines of Credit
Home equity loans come in two forms: fixed rate loans and home equity lines of credit (HELOC).
Fixed rate home equity loans provide a single, lump sum payment to the borrower, which is repaid over a period of time (usually 5 to 15 years) at an agreed interest rate. The payment and the interest rate remain the same for the duration of the loan. The loan must be repaid in full if the house on which it is based is sold.
A HELOC is a revolving line of credit, much like a credit card, which you can use as needed, repay, and then use again, for a period of time determined by the lender. The draw period (5 to 10 years) is followed by a refund period when the draws are no longer authorized (10 to 20 years). HELOCs generally have a variable interest rate, but some lenders may convert to a fixed rate for the repayment period.
Pros and Cons of a Home Equity Loan for Consumers
Home equity loans have a number of key benefits, including cost. But there are also disadvantages.
Home equity loans are an easy source of cash and can be a valuable tool for responsible borrowers. If you have a stable and reliable source of income and know that you will be able to repay the loan, its low interest rate and possible tax deductibility make it a wise choice.
Getting a home equity loan is quite simple for many consumers as it is a secured debt. The lender performs a credit check and orders a home appraisal to determine your credit worthiness and the combined loan-to-value ratio.
The interest rate on a home equity loan, although higher than that on a first mortgage, is much lower than that on credit cards and other consumer loans. This helps explain why the main reason why consumers borrow against the value of their home via a fixed rate home equity loan is to pay off credit card balances.
Home equity loans are usually a good choice if you know exactly how much you need to borrow and what you’re going to use the money for. You are guaranteed a certain amount, which you receive in full at closing. “Home equity loans are generally preferred for larger and more costly purposes such as remodeling, paying for higher education or even debt consolidation, because the funds are received in one go,” says Richard Airey, loan manager at Finance of America Mortgage in Portland, Maine.
Be aware that home equity loans can also be risky. The main problem with home equity loans is that they may seem too easy a solution for a borrower who may have fallen into a perpetual cycle of spending, borrowing, spending and getting deeper into debt. Unfortunately, this scenario is so common that lenders have a term: reloading, which is essentially the habit of taking out a loan to pay off existing debt and free up additional credit, which the borrower then uses to make purchases. additional.
Reloading results in a spiraling debt cycle which often convinces borrowers to turn to home equity loans offering an amount representing 125% of the equity of the borrower’s home. This type of loan often comes with higher fees because, since the borrower has taken out more money than the house is worth, the loan is not fully secured by collateral. Also note that the interest paid on the part of the loan that is greater than the value of the house never tax deductible.
When you apply for a home equity loan, there may be some temptation to borrow more than you need immediately because you only receive payment once and are unsure whether you will be eligible for a loan. another loan in the future.
If you are considering a loan that is worth more than your home, it may be time to check reality. Have you been unable to live within your means when you only owed 100% of the equity in your home? If this is the case, it will probably be unrealistic to expect you to be better off when you increase your debt by 25%, plus interest and fees. This could become a slippery slope toward bankruptcy and foreclosure.
Questions to Consider When Buying a Home Equity Loan
Before taking out a home equity loan, be sure to compare the terms and interest rates. When you look, “Don’t just focus on the big banks, but consider a loan from your local credit union,” recommends Clair Jones, real estate and relocation expert from Movearoo.com. “Credit unions sometimes offer better interest rates and a more personalized account service if you’re ready to face slower processing times.”
As with a mortgage, you can request an estimate in good faith. But before you do that, make your own honest estimate of your finances. Casey Fleming, mortgage advisor at C2 Financial Corporation and author of “The Loan Guide: How to Get the Best Possible Mortgage”, says: “You should have a good idea of where your credit is and the value of your home before applying, in order to save money. Especially on the evaluation [of your home], which represents a major expense. If your appraisal is too low to support the loan, the money is already spent ”- and there is no refund for non-qualification.
Before signing, especially if you are using the home equity loan for debt consolidation, run the numbers with your bank and make sure that the monthly loan payments will actually be lower than the combined payments of all of your current obligations. Even if home equity loans have lower interest rates, your term on the new loan could be longer than that of your existing debts.
Suppose you have a car loan with a balance of $ 10,000 at an interest rate of 9% with two years remaining. Consolidating this debt into a home equity loan at a rate of 4% with a term of five years would actually cost you more money if you took the five years to pay off the home equity loan. Also remember that your home is now the loan guarantee instead of the vehicle, so if you miss the home equity loan, your home is at stake, not your car. Losing your home would be much more catastrophic.
Home equity loan balance sheet
A home equity loan can be a good way to convert the equity you have accumulated in your home into cash, especially if you are investing that money in home renovations that increase the value of your home. But always remember that you are putting your house on the line: if property values go down, you may end up owing more than what your house is worth. If you then want to move, you may end up losing money on the sale of the house or be unable to move. And if you get the loan to pay off the plastic, resist the temptation to run those credit card bills again. Before you do something that knocks your house down (or deeper into hock), weigh all of your options.