Is a Home Equity Loan Right for You?
Home equity loans are big news these days, but are they right
for you? First, before you can decide, you need to know the
facts about home equity loans. Home equity loans come in two
different forms: closed-end home equity loans and home equity
lines of credit.
Closed-end home equity loans are very similar to your home
mortgage: a specific amount of money is loaned to you and
youre required to make scheduled monthly repayments
of principal and interest. These loans are often thought of
as traditional second mortgages. The date you must repay the
loan is set when you borrow the money. Often interest rates
In contrast, a home equity line of credit is more like a
credit card. Home equity lines of credit allow you to use
as much (or as little) of the credit line as you like, up
to an approved dollar amount. You can withdraw money when
you want to use it. Typically you have between five and 20
years to access this credit line. Once this period has ended,
you must stop borrowing and repay the principal and interest.
You may have between 10 and 20 years to repay, or you may
have a balloon payment. Balloon payments require you to pay
the principal in one lump payment. Often the credit interest
rate is adjustable and changes as the economy changes.
Advantages of Home Equity Loans
Low rates. Interest rates tend to be lower than
credit card rates or consumer loans.
Tax-deductible. The interest you pay is tax deductible
up to $100,000 or the equity value in your home, whichever
is less. Consult a tax advisor for details.
Flexible. The loan allows you to choose when to
use the money. Plus, you may be able to decide when to repay
Disadvantages of Home Equity Loans
Risk of losing home. If you cant repay or
refinance the loan, then you may be forced to sell or lose
your home. Your home is the collateral for the loan. Being
late or missing loan payments can trigger foreclosure within
60 to 90 days.
Rising interest rates. With a variable interest
rate, most home loan rates change when the economy changes.
This means your monthly payments can rise and fall. Be sure
you know what the cap is on the loans interest rate.
The cap sets how high your interest rate can increase each
year as well as how much it can increase over the whole
loan time period.
Fees. Lenders can charge a variety of fees including
origination, application, and withdrawal fees. Be sure to
ask about all possible fees.
Success with a Home Equity Loan
Compare loans. Home loans characteristics
vary depending on the financial institution lending the
money. Interest rates, fees, repayment conditions, loan
amount, and additional costs such as points can all vary.
For example, a lender may charge an annual fee for using
your home equity line of credit or even a larger fee if
your credit line is inactive. Check with several lenders
to find the loan that suits you the best. Use the Home
Equity Loan Comparison chart, to help compare loans.
Read all the fine print. Understand the loan conditions
before you sign the contract. When can the credit line be
frozen? What is the interest rate cap? How often is the
interest rate adjusted? Which index is used to calculate
the rate? Can the lender demand full payment and how quickly
must you pay back the loan?
Plan how you will use your loan. Dont use
your loan for items that get used up such as clothing, entertainment
and minor repairs. Even if the lending institution offers
you a credit card to access your credit line, consider refusing
it. A credit card may make using your loan too easy. You
may find yourself deeper in debt than you planned.
Set up your own repayment schedule. When you borrow
money from a home equity line of credit, you may have the
option of making very small payments over a long time. However,
its smart to pay more than the minimum required. For
example, if you borrow money to buy a car, you dont
want to be paying for it 20 years later. Plan to repay your
loan using the following guidelines: 18 months to repay
a loan used to consolidate debt; three to four years to
purchase a car; no more than seven years to pay for a home
Estimate How Much Money You Can Borrow
How much can you borrow? This depends on both the equity
value you have
in your home and the lenders policies. Your home equity
is the difference between its
appraised value (the price that you could sell your home)
and your mortgage value (what you owe
on your loan). Use Table
1 to calculate your home equity value.
Lenders consider several factors (such as your credit history,
ability to repay the loan, and your homes equity) when
deciding how much money to lend. Lenders often use one of
two methods (shown in Table
2) to calculate how much they are willing to loan you.
The calculations in Table 2 are based on your home equity
value. Each lender sets its own guidelines about the loan-to-value
ratio to use; typically its between 75-85 percent.
- Method 1) 75 percent of the appraised value of
your home, less your unpaid mortgage.
- Method 2) 75 percent of your homes equity.
As you can see from the example in Table
2, the amount you can borrow will depend on the method
the lender uses. Method 1 is more commonly used. Be aware
that Method 2 may result in borrowing more money than you
can comfortably handle. For example, home equity loans must
be paid off if you sell your home. With a high loan-to-value
ratio, such as in Method 2, this might be difficult to do.
If you decide to get a home equity loan, use it wisely. You
will have a useful money manage-ment tool.
Written by Kathy Sweedler, Consumer and Family Economics
Extension Assistant, University of Illinois Extension.