Home equity loans are the funds you can borrow against the value of your home. As you continue to pay off the instalments of your mortgage, you accrue equity or ownership in the home. If you have paid off a large section of your mortgage and the property is worth more than the remaining mortgage, you can raise loans against it. Further, given that you’re offering collateral, it is easier for you to get approval for various other kinds of loans.

The mortgage you take when you buy the house is your “first mortgage.” But, the home equity loan that you take on the paid off section of the first mortgage is considered your “second mortgage.” While taking a home equity loan has its positives, you may want to be aware of the possible pitfalls.

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Positives of Taking an Equity Home Loan

As a borrower looking to raise funds against the property you own, you’ll find that the process is a lot easier than when getting the first mortgage. Here are some of the positives:

  • You may find it easier to get approved for the loan even if you have an unsatisfactory credit score. However, keep in mind that while you do have the home equity to offer as collateral, prospective loan providers may ask for various additional documents. Further, they typically have stringent borrowing conditions that may make it difficult to get the loan.
  • You’ll pay a lower rate of interest or APR for the home equity loan since the loan is secured unlike taking a personal loan or credit card which are unsecured loans. However, you may want to assess the closing costs carefully before taking the loan.
  • If you have a large equity on the home, you could qualify for bigger loans. These funds can be used for starting a new business, paying for higher education, or making renovations to the property.

Why Lenders Agree to Home Equity Loans

Making loans to borrowers against their home has several positives for lenders as well. Here’s how:

  • Given that your house is collateral for the loan, the funds are secure and banks are willing to provide the money to you. In case you cannot honor payments, the bank can always foreclose and sell your home to recover the unpaid balances.
  • In case you’re running low on funds, given a choice between clearing say, a credit card bill or the installment on your home equity loan, you’re likely to pay off the loan. That’s because you would not want to lose your home. This factor makes the loan more secure.

Getting Approval for the Home Equity Loan

Even though you’re offering your home as collateral, getting approval for the home equity loan may not be all that easy. Here are a few factors to keep in mind:

  • Prior to 2007, lenders were more open to offering first and second mortgages. After the housing crisis, loan providers have stricter approval criteria and will assess your application against them.
  • To ensure that you don’t take loans worth more than 80% of your property value, lenders are likely to take into account the first mortgage also. In this way, they get assurance of getting paid back.
  • Each bank may use its own loan to value (LTV) ratio or percentage of the value of the property available when evaluating your application.
  • To qualify for the loan, you will have to provide proof of your income along with tax records to the lender for the verification of your finances and ability to honor payments.

Types of Home Equity Loans

Home equity loans can be of two kinds:

  • Home Equity Line of Credit (HELOC): Should you apply for this loan, you can get approval for the maximum loan amount. However, you are allowed to borrow only the funds that you actually need any number of times. In the initial years after taking the loan, also called the draw period, you can pay off smaller amounts. But, after a preset interval which is typically 10 years, you must make amortizing payments regularly to pay off the loan.
  • Amortizing Loan or Lump-Sum Loan: This loan is like any other loan where you can receive a large amount of funds at a fixed rate of interest. You’ll make prefixed payments each month to reduce the balance you owe and cover some of the costs of interest.

Comparing the Types of Home Equity Loans

Given a choice between the HELOC and lump-sum loans, you’ll find that the HELOC has several positives. For instance, The HELOC allows you to draw only the funds you need and pay interest on the funds you’ve actually drawn. However, you run the risk of your lender canceling or freezing your line of credit at any time. If this situation occurs when you urgently need the funds, that could be a problem. Further, HELOC loans come with a variable rate of interest which can become high or low depending on market conditions.

Finding the Home Equity Loan Best-Suited for Your Needs

Ready to apply for that home equity loan? Here’s how to proceed:

  • At the time of taking home equity loans, you may want to shop around with the different lenders including banks, credit unions, online or national broker, or a local mortgage provider. Check websites and advertisements to find the best loan available. You can also ask friends and family members for references of good sources of loans.
  • Compare the rates of interest and other terms and conditions lenders offering and choose the most economical loan product. You may find that having a good credit score works in your favor and you could get more attractive interest rates.
  • Check your credit report for any inaccuracies. If you spot any errors or minor issues, work out how to fix them quickly using the rapid rescoring process so you have a better report to show prospective lenders.
  • Request for appraisals for a clear view of the maximum loan you can take along with the applicable interest and other closing costs. Typically, home equity loans may take time to get approved and it may be a while before the funds are made available to you similar to taking a home loan. To speed the process along, it helps to have the necessary documents ready like, for example, pay stubs and other proofs of income.
  • Study the loan appraisals carefully and ensure that your home has been valued correctly.

Downsides of Getting a Home Equity Loan

While getting a home equity loan has its positives, you may want to explore the pitfalls carefully before taking the loan. Here are some of the risks to be aware of:

  • In case you cannot keep up with the monthly payments as required by the lender, you stand to lose your home.
  • Taking loan against your home typically involves paying hefty closing costs even before you get the funds in your hand for using. If you need only small sums, it may be advisable to opt for the HELOC so you can pay back the loan amounts easily and incur only a limited amount of interest.
  • Before taking the home equity loan, you may want to explore the reasons why you need the funds. If you’re going to use the money for purposes that add value to the house or raise your family income in some way, go ahead and get that loan. Make the clear distinction between a good debt and bad debt, and essential or frivolous expenses.

Take a look at the typical uses that would make sense to take out a second mortgage:

  • Consolidating debts for which you’re paying a high rate of interest
  • Raising the funds for a college education for a family member
  • Making improvements and renovations in the property that can raise its value
  • Using the funds to buy a second home, landed real estate, or any other lucrative investment

Questions to Ask Yourself Before Taking that Loan

  • Do I need a home equity loan or can I get by with a credit card or any other unsecured loan? While you might pay higher rates of interest for unsecured loans, you could avoid the hefty closing costs of getting the home equity loan.
  • Will I be able to cover the repayments? Budget your income and expenses carefully and ensure that you can cover the large repayments each month. In case you’re considering a loan with a variable rate of interest, rising rates may make it difficult to keep up with payments. Check if you can cut back your expenses to avoid taking the loan altogether.
  • Are there any cheaper loan options out there? Before finalizing your decision to take the home equity loan, look for more economical loan products.
  • Can I maintain insurance coverage? Make sure you can keep paying life and disability insurance premiums. You do have the option of including coverage in your home equity loan though that is not mandatory. If you choose this option, choose the monthly premium plans in place of the up-front option. In this way, you’ll pay interest on only the actual amount you borrow.

Other Factors to Keep in Mind

  • Prior to the Tax Cuts and Jobs Act of 2018, you could have claimed deductions for the interest you pay for home equity loans. But, this deduction was possible only if you were taking the loan for conducting renovations and improvements on your current home. This facility no longer exists, so you may want to keep that in mind when taking the loan.
  • If you’re a senior citizen looking to take a home equity loan to supplement your household expenses post retirement, you could consider reverse mortgages as an option. While you might find that qualifying for the loan is easy, it may be advisable to take a close look at the risks before finalizing the loan.