A home equity loan, also known as a second mortgage, is a type of loan that is taken by homeowners by offering their homes as security.
Home equity loans are generally easier to obtain as the home offered as collateral reduces the risks associated with loans for lenders.
Since home equity loans are secured debts, the interest rates on home equity loans are also lower than other types of loans and debts.
Home equity loans can provide many benefits to the homeowners borrowing the loan and to the institution that is offering the loan.
Homeowners can obtain a home equity loan by evaluating different lenders and selecting the lender that meets their expected demands and is also cost beneficial.
Lenders also have a set criterion on who they will allow loans to be provided to. Generally, lenders do extensive checks on the credit rating and financial background of the homeowners. Once these checks are passed, a loan limit amount is determined.
The amount of home equity loan is based on the Loan To Value (LTV) ratio of the home being offered as collateral.
This is the amount of loan that is given compared to the value of the home being offered as security. Lenders generally prefer to keep the LTV ratio between 80% and 90%.
So, the loan provided to the homeowner is always kept between 80% and 90% of their home equity. However, the remaining amounts of mortgages or any other loans on the house are deducted from the calculated amount before the loan is given.
For instance, a loan provider wants to keep the LTV ratio for the home equity loan they provide at 85%.
A homeowner with a home that is valued at $300,000 in the market with remaining mortgage payments of $210,000 wants to acquire a home equity loan. The total amount of home equity loan using the optimal rate of 85% will be $45,000.
This is calculated by first multiplying the value of the house with the LTV ratio ($300,000 x 85%) and then reducing the mortgage payments from it ($255,000 – $200,000).
Home equity loans have two main types. The first type of home equity loan is the fixed-rate home equity loan. It is the most common type of home equity loan.
In a fixed-rate home equity loan, a lump sum amount of the loan is provided to the borrower. The rate of interest, as the name suggests, is fixed in this type of loan.
The second type of home equity loan that can be obtained by homeowners is the home equity line of credit. In this type of home equity loan, the amount provided as a loan is variable and at the discretion of the borrower.
The borrower decides how much they want to take as a loan. Usually, a limit is set by the lender for both the minimum and maximum amount of loan under this type of loan. The interest rates in this type of loan are variable.
Homeowners don’t only have the home equity loan at their disposal. Homeowners can also obtain other types of loans such as cash refinancing, a type of loan that is added to the mortgage of the home.
Other than loans that are obtained by providing a home as security, homeowners can also obtain unsecured loans. They can obtain personal loans or even use their credit cards if the loan required is not of a high amount.
Home equity loans can be easier to obtain and offer lower interest rates and that’s why it might be a good idea for some homeowners to obtain home equity loans.
However, it might also be a bad idea in some circumstances. Ultimately, the decision whether to take or not to take the loan is for the borrower to make.
When is Obtaining Home Equity Loan a Good Idea?
There are many reasons why a home equity loan may be a good idea.
When credit rating matter
As suggested before, home equity loans are easier to obtain due to the home that is provided as security.
However, this loan is given only after different types of checks are performed on the borrowers. One of these checks is the credit rating check of the borrower.
While the credit rating requirements for borrowers are lower for home equity loans than for other types of loans, the credit ratings of the borrower still dictate the terms of the home equity loan.
Therefore, for homeowners that have a bad credit rating but want to obtain a loan for any reason, home equity loans might be the best option out there.
When homeowners have regular income sources
As mentioned above, homeowners are put through some checks to determine whether a loan should be given to them or not.
Only homeowners that can meet these requirements can obtain the loan.
Having a regular income source not only helps homeowners meet these requirements but also helps with future interest payments.
When emergency funds are required
Sometimes, homeowners may require emergency funds for personal reasons. Due to the ease of obtaining a home equity loan, they can be a great candidate for the purpose.
For emergency funds, a home equity line of credit may be the best option as it allows the borrowers the flexibility of deciding the amount of the loan they want to obtain and increase that amount later if required.
When the loan can help in tax planning
Interest payments on home equity loans are tax-deductible for the borrowers.
However, there is an added condition to the usage of the loan for the interest payments to be allowed as tax deductions. The condition is that the loan should only be used for home improvements.
This means that when homeowners obtain a home equity loan and use it to improve the home, for example, by making renovations or additions to the home, the interest payments are tax-deductible.
Homeowners looking to renovate their homes can use home equity loans instead of other types of loans, or personal funds.
This can help homeowners reduce their taxes while benefiting from the loan.
When consolidating high interest debts
Since home equity loans are offered at a lower rate than other types of loans, they can be used by homeowners to consolidate other high-interest debts they may have.
This means that if a homeowner has other debts that require interest payments at a higher rate, they can take the lower interest rate home equity loan and use the money to pay for the higher interest rate loan and later repay the home equity loan at a lower rate.
When a lumpsum amount of cash is required
If homeowners require a lump sum amount of cash, a home equity loan can be a good option.
In a fixed-rate home equity loan not only are borrowers given the loan in cash but the payment is also made upfront.
This can be a great idea for homeowners who have expenses to pay that require a lump sum amount payment.
When is Obtaining Home Equity Loan a Bad Idea?
Obtaining a home equity loan can also prove to be a bad idea for some homeowners in the following circumstances.
When homeowners plan to sell their home soon
If the homeowner does not expect to keep the home, which they want to offer as collateral, for long, it might not be a good idea to obtain a home equity loan on that home.
That is because the value of home equity is the fair value of the home in the market minus any remaining payments on the home.
This means that if a loan is taken on the home, the homeowner is planning to sell soon, the value of the home’s equity will be decreased by the amount of loan taken.
If a home equity loan is taken on a home that the homeowner is going to sell soon, the home equity loan will have to be paid first in its entirety before the home can be sold.
When homeowners’ source of income is unknown
For homeowners who do not have a constant source of income, a home equity loan may be a bad idea.
If homeowners do not know how and when their next income is going to generate, a home equity loan can be a risky option to avail.
This is mainly because the homeowners provide their homes as security. In case of defaults on payments, whether interest or principal amounts, they can lose their homes.
When real estate values are declining
If a home equity loan is taken when real estate values are declining, then the homeowners may owe more than what their homes are worth in the market.
Homeowners should only take a home equity loan when real estate prices are expected to grow or stay constant.
This way, homeowners do not have to pay more than their home’s worth.
When the costs outweigh the benefits
Homeowners should always perform a cost vs benefit analysis to determine whether the costs on the loan can be recovered by the benefits that the loan will provide.
Apart from interest payments on the loan, home equity loans also need costs to be borne for opening and closing the loan. This is unlike other loans where these costs are either nil or minimal.
Home equity loans are loans taken by homeowners by offering their homes as security. Home equity loans can either be a good idea or a bad idea depending on the circumstances.
For instance, home equity loans can be a good idea in circumstances when the credit ratings of the homeowners are low, when homeowners have regular sources of income, or when these loans are used to consolidate other high-interest debts.
They may be a bad idea in circumstances such as when homeowners are planning to sell their homes soon, they have unknown sources of income, or when the costs of the loan outweigh its benefits.