You and your family are the souls of your house; in reality, you make the bricks and concrete model a “dream home”. Owning a house is by no means a small feat; billions of people around the globe are still struggling to own one.
You saved money from your business operations, used your retirement funds, or applied for the first mortgage to build a house; you have done an exceptionally good job.
You’ve accumulated credit card debts, you need some funds for your children’s college education, or you need some home repairs done; you’ll be looking for a quick and easy debt option.
When you own a house it’s an asset for you, when you apply for a loan against it the asset becomes “equity” in finance terms.
“A loan secured against the collateral value of a homeowner” is called a home equity loan. This type of loan is granted against the market value of a home at the time of the loan application.
A home equity loan is often termed as the second mortgage because a large number of people applying for a home equity loan use it as a second mortgage option. The term home equity loan can often be mixed with “refinancing”; however, it is different in characteristics.
There are certain pros and cons associated with a home equity loan, before that understanding the characteristics of a home equity loan will understand the concept.
- Banks and lenders offer home equity loans using your home as a collateral
- The loan value depends on the credit score and the market value of the home, the lenders usually offer up to 80% of home value.
- The installments are fixed payments over 5 to 15 years
- The home equity loans are charged with fixed interest rates
There are two types of Home Loans associated with a collateral financing facility, A Home Equity Loan, and a Home Equity Line of Credit. Both the loans are granted against home collateral, for the sake of clarity of this article, we’ll be looking at the Home Equity Loan or HELOAN option.
A Home Equity Line of Credit or HELOC is a different loan facility which is a revolving term credit. The Home Equity Loan is obtained in a lump sum amount against a fixed monthly installment and a fixed interest rate.
Why do people opt for Home Equity loans?
The simplest of the notions is that it is easy to avail. When the loan is backed by collateral as precious as a home, the loan is termed “secure” which makes it is a less expensive option.
Certain risk factors associated with a Home Equity Loan make it a more cumbersome option; often the benefits associated with a HELOAN get overweighed with the associated disadvantages.
We’ll look at five compelling reasons that make a Home Equity Loan a more risky option.
BAD FOR YOUR CREDIT SCORE:
A Home Equity loan is often applied as a second mortgage option. People when in need of cash for several reasons like education, house modifications, or settling credit card debts apply for a Home Equity Loan.
If the consumer does not use the full amount of credit limit available their credit score is unaffected, but then why would they apply for a loan? Your credit score bears a small brunt when you apply for a Home Equity Loan, especially when you are using it for your debt consolidation purpose.
In the longer term, however, if the payments are missed your credit score hurts quite badly. A bad credit score would eventually mean you run out of refinancing options too, or the next credit facility will up with a high-interest rate.
YOUR HOME is at RISK:
Debt consolidation is often a good option considering the low-interest rates associated with a Home Equity Loan. Businesses around the globe are more volatile than ever, which affects everyone, doesn’t matter if you’re a business owner or a government officeholder.
Prepare yourself for a worst-case scenario too, if you lose your income stream and do not settle off your Home Equity Loan you may lose your HOME.
Compare the impact of losing a home with a vehicle? In another scenario, if the market for the real estate sector sees a downfall, your house value decreases immensely. A fall in your house value means you owe the bank more now than you originally borrowed.
The ghosts of the global financial crunch in 2008 still resonate! One more drawback of a fixed monthly installment loan facility is that it often does not include the option of early settlement. If there are options for early settlement of your equity loan they’re often expensive.
THE TAX BENEFIT IS RELATIVE NOW:
All types of loans have two segments a principal amount and an interest associated with it. A Home Loan Equity facility had the option of having the interest rate expenses as tax-deductible, but that has changed now.
With the new tax cut and jobs act since 2017, the home equity loan interest is tax-deductible conditionally. Only IF the loan is used for uplift or improvements for the house itself the interest expenses will be treated as tax-deductible.
When you apply for a HELOAN for debt consolidation, education, or health expense uses, etc the interest will not be treated as a tax-deductible expense.
THE TRAP OF RELOADING:
The single biggest advantage associated with a Home Equity Loan is that it is easy to avail. You get a loan up to 80% of your house market value, even 90% in some cases, pay fixed monthly installments, and enjoy a low-interest rate.
A large percentage of applicants for HELOANs apply it for debt consolidation, after a few years of monthly installments, the customer gets an option of “reloading” the loan amount.
The banks and other lending unions lure in the customers to this option. One of the most common pitfalls of the Home Equity Loans observed is that people often go for a “reload” facility and continue to do so. With the addition of new loans, the collateral value of the house may not be enough to cover the total debt amounts.
SHORT-TERM and LONG-TERM COSTS:
A Home Equity Loan comes with a fixed monthly rate plan. It is often applied as a second mortgage which makes the interest rates expensive in the long term.
The closing costs associated with Home Equity Loans range between 2% to 5%. One important point to consider is that few credit unions and banks have a threshold loan facility amount for HELOANs, which may be a lot higher than your current needs.
The current tax cut and jobs act reforms have also made an impact on the overall cost of the HELONs, if the interest is NOT tax-deductible the interest payments over a long period of 10-15 years become much more expensive than a normal mortgage facility.
If you apply a HELOAN against a fully owned house the Private Mortgage Insurance is not required, but often the case is for the second mortgage.
When the loan to value percentage rises above a safe limit (> 80%) the lenders require a PMI as a risk cover. That PMI is an additional cost, and it becomes expensive as the LTV increases.
There are considerable benefits and disadvantages of a Home Equity Loan facility. The temptation to apply for it is, it’s easy to avail. Like any other loan facility, the starting point will be your loan qualification.
The banks and credit unions do not want a risky deal, so should you avoid the risks. A HELOAN is backed by collateral, comes with a fixed installment plan, and a facility up to 80% of the house value.
As in any case, the HELOAN will also be a difficult option for people with low income, the credit score will be lower, and the banks will deem the facility risky. All that means in simple terms is that the loan becomes either difficult to avail or expensive.
Low-income persons may be in a more risky position using this option, and in case of a default, the banks may foreclose the loan facility. The case for people with a bad credit score is also similar, but simply the more risky a loan deal is the more expensive it gets.
If you are applying for a House Equity Loan facility for your debt consolidation it might be a good option for you, especially if your credit score is healthy and you have a good stream of income.
For other tempting purposes like house renovation, educational expenses, and even a vehicle loan; you should consider more flexible and better options like a credit card or a personal loan.
The amount of loan approved and rate charges will depend on the value of the collateral house and the credit score but it is worth mentioning that your house is at risk.
Remember the two most important factors; devaluation in your house price due to any economic situation which is beyond your control and any loss of income stream will make the loan deal riskier.