What is a home equity loan?
A home equity loan allows you to borrow money against the equity in your home. Home equity is the value of the home less the amount or any mortgage debt outstanding. With a home equity loan you receive a lump sum payment and then repay the loan over a set period of time at a fixed interest rate. A home equity loan is typically a loan for a fixed amount. These loans generally have a fixed rate of interest and are paid over a fixed term, just like your original mortgage.
A home equity loan differs from a home equity line of credit or HELOC. A HELOC is a line of credit against the equity in your home that you tap as needed. Repayment terms can vary and in some cases there can be a balloon payment due at the end of the loan term. The interest rate might also be variable.
The current tax rules based on the tax reform passed at the end of 2017 no longer allow the interest paid on home equity loans or HELOCs to be deducted for tax purposes unless the money is specifically used for home improvements or related items as specified by the IRS.
Why do I need a home equity loan?
You might need a home equity loan to refinance a home improvement, to pay down other higher cost debt, to cover major unexpected medical bills, to pay the costs of college for your children or other major expenditures.
A home equity loan may be a less expensive option than an unsecured personal loan. This is due to the added security having your home as collateral offers to lenders. The secured nature of the loan may offer an opportunity for borrowers with lower credit scores.
On the other hand, it is important for borrowers to understand the fact that they are using the equity in their home as collateral for this loan. If they run into financial difficulties that prevent them from making the required payments they may be putting their home at risk. They should also look at the useful life of what they are using the money for versus the time horizon over which they will need to make payments on the home equity loan to fully evaluate the economics of using this type of loan.
Is now the right time?
Some factors that might be enticing to borrowers include low interest rates and perhaps the need to access emergency cash due to some sort of economic hardship. Whether or not now is the right time for a home equity loan will depend upon the individual circumstances of each borrower.
Factors to consider include the stability of the borrower’s employment situation, likely trend of home values in their area and their need for the money.
Home equity loans and COVID-19
Just as with other types of mortgages, many lenders have tightened their lending requirements for borrowers looking for a home equity loan in light of the economic decline resulting from the COVID-19 pandemic. This may include requiring a higher credit score and perhaps a stronger financial situation than in past years.
The Consumer Financial Protection Bureau has recently waived some of the requirements when applying for mortgages, including home equity loans. One requirement that has been waived is the three day right to rescind the loan. This was designed to get money into the borrower’s hands more quickly during the COVID-19 situation. While this can be helpful, it’s important to be sure that you understand all loan terms and conditions before moving ahead.
As far as HELOCs, there have been a number of lenders who have suspended activity with these lines or who have tightened their requirements in the wake of the financial fallout from the pandemic.
How to choose the best home equity lender
Finding the best lender for a home equity loan will depend upon your unique situation and needs.
Choosing the right lender for our situation will require some homework on your part to determine what loan features are important to you and what type of borrower you are.
Do I need good credit?
Requirements will vary by lender, but generally they want to see a credit score of 620 or above. Many lenders will require a higher score, especially with the tightening of requirements for borrowers in light of the COVID-19 pandemic.
It’s important to understand that home equity loans are essentially second mortgages and while the loan is secured by your home equity, the home equity lender is often in a second position to the lender on your first mortgage. In the event that the borrower defaults on their mortgage loans, the lender on the first mortgage is first in line to be paid, the lender on the home equity loan would be next. As long as there is enough home equity, and the home sells for a sufficient amount to cover both loans there is no problem. However, this isn’t always the case.
That all said there are some lenders who will grant a home equity loan to borrowers with bad credit. You will need to shop for those loans.
How is this different from a personal loan?
A personal loan is an unsecured loan that is granted based on your credit worthiness or that of your cosigner if applicable. Lenders are taking on a greater risk by making an unsecured personal loan, so the rates may be higher than a home equity loan in some cases. In some cases, a personal loan may be secured by some sort of collateral.
Personal loans can be used for a major purchase, to consolidate higher cost debt such as credit cards or any other purpose the borrower desires. They can be a better alternative for those who are uncomfortable putting the equity in their home up as collateral for the loan.
What is a cash-out refinance?
A cash-out refinance is a new loan on your home for more than you owe on the mortgage you are refinancing. The extra cash borrowed can be used by the borrower for any number of purposes such as home improvements, consolidating debt or other financial needs.
A cash-out refinance may carry a higher interest rate than refinancing for just the amount you owe on your existing mortgage. Most cash-out refinance loans will limit the amount borrowed to 80% or 90% of your home equity.
Are there any alternatives?
Probably the two main alternatives to a home equity loan are personal loans and a cash-out refinance. Sometimes a cash advance against your credit cards is also suggested as an alternative, but this can get expensive. Many credit card issuers advertise 0% cash advances for a period of time, but if the advance is not paid off within a certain time frame, the interest rate can shoot up very quickly.
A reverse mortgage may be an alternative for those who are age 62 or over. These loans provide cash to the borrower and allow them to stay in their home. The loans are usually paid off when the home is sold, often after the borrower’s death. There are a number of government requirements, including mandatory educational requirements for prospective borrowers.
A home equity loan can be a great financial tool for the right borrower in the right situation. If you are considering a home equity loan be sure to understand how it matches up with your situation. Be sure to shop for the best lender and the best terms for your situation.