What is a home equity loan?
Home equity loans, also known as second mortgages, are secured by the borrower’s home and paid in a lump sum. Lenders can extend loans up to 85 percent of a borrower’s home equity. After disbursement, the borrower will have to pay interest on all loan amounts. Interest rates are generally around prime plus 2 %, but it depends on factors like credit history and income.
What is a home equity loan?
A home equity loan is a fixed rate, lump sum loan secured by the equity of the borrower’s home. This loan allows homeowners to borrow upto 85% of their home’s equity and then pay it back monthly over a five- to 30-year period, depending on the loan term.
The borrower is not eligible for a home equity credit (HELOC), but he or she receives the full amount of the loan upfront. Rather than borrowing against it as needed. Due to this immediate loan payout, the borrower will have to pay interest on the entire loan amount.
How can you calculate home equity?
A lender can determine how much loan an applicant will need by using home equity. Calculating your home equity starts with the appraised worth of your house. Next, subtract the amount of any loans secured by your home. This will include mortgages and home equity lines credit, as well personal loans or other debts secured by the property.
Home’s market value – Total loans secured by home = Home equity
As part of the loan underwriting process, a lender might require a formal home appraisal. You can estimate the value of your home using websites such as Zillow or Realtor.com.
Let’s say that the owner of a $450,000 property has $350,000 remaining on their mortgage. The owner of a $450,000 home has $100,000 equity. But, if the pool was built with a $50,000 personal loan, their equity is only $50,000.
How a Home Equity loan works
Home equity loans can be a convenient way to get cash out of your home. You borrow against your equity. If homeowners are facing large expenses, such as a remodel of the kitchen or a wedding, they can reach out to their mortgage lender or another loan broker to apply for a loan. This process is similar to applying for a HELOC. The closing costs and fees that the borrower has to pay are typically between 2% – 5% of the total loan amount. These additional costs may be waived by lenders.
The home equity loan is secondary to the mortgage because it is secured by the borrower’s house. This puts the home equity lender at greater risk since it is not paid until the first mortgage lender pays.
The loan is then paid to the borrower in a lump sum. In addition, the borrower has to pay interest on the total amount of the loan. Because the loan is secured by a borrower’s house, the lender may foreclose the property if the borrower defaults on payments.
Average home equity loan interest rate starts at prime plus 2%. But, a borrower’s actual interest rate will depend on their income, credit history, and employment. Lenders take into account the equity in the applicant’s home as well as their debt-to-income ratio. This is the sum of the borrower’s monthly payments divided by their gross income.
HELOC Vs. Home Equity Loan
Home equity loans are issued by the lender to homeowners at one time. They have a fixed rate of interest. Like traditional loans, the borrower is required to pay monthly interest on the entire loan amount. The loan term can range from five to 30 years. A home equity loan is a good option if you are facing large home improvements, weddings, medical bills, or other one-time expenses.
The homeowner can be approved for a HELOC but not for a large sum of money. The draw period lasts approximately 10 years. Borrowers can withdraw funds against their line of credit as needed. However, they are responsible to pay interest only for any withdrawals. HELOCs have an interest rate of around prime plus 2%, similar to home equity loans. HELOC interest rate are variable so the borrower might be subject to higher rates if the prime is raised.
After the loan period ends, the HELOC borrower will have to pay both interest and principal over the next 20 years. HELOCs can be used to cover ongoing expenses such as college tuition or long-term home renovations, or any other predictable or recurring costs.
Limits on Home Equity Loan Borrowing
A lender will consider several factors when determining home equity loan borrowing limits. These include the applicant’s income, credit score, and home equity. Home equity loans are secured by the borrower’s home. Lenders must also know the property’s value as collateral. To determine the market value, your lender might require you to complete a formal appraisal. The lender will generally limit loans to approximately 85% of the applicant’s home equity. However, this number can vary depending upon the applicant’s qualifications.
In the example above, the homeowner owned $100,000 in home equity. The homeowner could be eligible for up to $85,000 if they meet all the requirements of the lender. If they have less than $25,000 in equity, however, the loan may be restricted to around $21,000.
Qualities for Home Equity Loans
Each lender will have its own requirements. Lenders will require you to meet these minimum requirements before they issue a loan.
- Credit score of 620 or more
- Home equity up to 15%-20%
- A record of income and employment proving that you are able to repay the loan
- A ratio of 43% and lower for debt-to income
- Tax deduction for home equity loan
Federal tax law enacted the Tax Cuts and Jobs Act in 2017. This means that homeowners are allowed to deduct the interest on their home equity loans. The first is that the loan must be used to “buy or build” the home of the taxpayer. However, the IRS clarified the IRS’s position that home maintenance such as painting a home does not count as a substantial improvement and can no longer be deducted from the tax deduction.
The Tax Cuts and Jobs Act has also reduced the amount that home equity debt can be deducted to $750,000 for a married homeowner filing separately and $375,000 if the couple is a household. This new cap doesn’t apply to mortgages that were obtained before Dec. 16, 2017. Mortgages that were taken out before Dec. 16, 2017 are exempt from this new cap. However, interest can still be deducted up to $1,000,000 per household and $500,000 for married couples filing separately.
Once you determine whether the home equity loan interest is deductible, you must also evaluate whether it’s more advantageous to take your itemized deductions–including the loan interest–or settle for the standard deduction. The standard deduction for 2020 tax year for married couples filing jointly is $24,800 ($12,400 for single taxpayers or married individuals filing separately; $18,650 if you are a head of household). This may be the best option for some taxpayers.
Alternatives to Home Equity loans
A home equity loan is a great option if your home has substantial equity and you need to cover some up-front costs. For those with low credit scores or little equity, this loan might not be an option. In addition, home equity loans might not be the best choice if you have long-term expenses that are spread out over time. You might consider a HELOC or another alternative before you commit to a mortgage.
Personal Loan
Personal loans can either be secured or unsecured. They are great for homeowners without much equity in their homes or for those who do not want to pledge collateral. Unsecured personal loan have a higher rate of interest than a secured personal loan. However, they are less risky since the lender is unable to foreclose the borrower’s house in the event of default.
Cash-Out Refinance
Homeowners can refinance their home to get more than they owe, and then receive the cash out as a lump-sum. The refi acts as a primary mortgage and is therefore less risky to lenders. This may allow borrowers to access a lower interest than a HELOC, home equity loan, or HELOC. If you are looking for help with large renovations, consolidating debt, and other large expenses, this is an option.
Credit Card
A credit card is a line credit that is not secured by any of your property or home, unlike a HELOC. Credit cards can be a good choice if you don’t have enough equity or aren’t able to get a personal loans quickly enough. Credit cards can be a form unsecured debt so they have a higher rate of interest and may not provide the spending power you require.
Benefits of a Home Equity Loan
- Lower interest rates than unsecured loans such as credit cards and personal loans
- Fixed interest rates allow borrowers to plan for their monthly debt payments more easily
- You may be eligible for a deduction of loan interest if the money is used to fund certain home improvement projects
Home Equity Loan Drawbacks
- The closing costs of appraisals and underwriting fees may be paid by the borrower. They can amount to anywhere from 2% to 5% of a loan amount.
- On the total amount of the loan, interest accrues
- You can reduce your equity in your house
- Risky: If the real estate market in your locality declines, you may end up owing much more than the fair value of your home.
- If you decide not to sell your home, you will have to repay the loan balance.
