5 Things to Know About Equity in the Home
Thinking about taking out a home equity loan? Here are five things you should know before moving forward.
There are Two Types of Home Equity Loans
It’s important to consider your financial needs - and when and how you’ll be using the funds - to determine which option best suits you.
- Closed End Home Equity Loan: This is your best option if you’re looking to obtain a lump sum payment. The uses for this loan are vast. You can use the funds to replace the roof on your home, finance a home improvement project, assist with debt consolidation, pay off a major unexpected expense, and so on. This loan type offers a fixed-rate loan – a loan that is paid back over a pre-determined amount of time. In most cases, you can expect a term of of 10 to 15 years to repay the loan, depending on the amount you borrow.
- Home Equity Line of Credit (HELOC): This option provides you a greater level of flexibility when it comes to using the funds, since it is a line of credit. HELOCs are often used for financing an ongoing home-improvement project, paying for higher education, or paying for recurring seasonal expenses, since it allows you to borrow the funds as the need arises. Interest is only paid on the amount that is borrowed. Unlike the closed-end home equity loan, the interest rate on the HELOC is adjustable (not fixed), which means the interest rate may change over the course of the loan. The draw-period (the allotted time to borrow on the loan) is up to 15-years (at 3Rivers), and HELOCs are amortized over 15-years as well.
Both options have closing costs, though they are significantly lower than what you’ll find with a First Mortgage loan product.
Equity is Required
Equity is the portion of the home that you own compared to that which you owe to the lender. In other words, if your home is valued at $150,000 and you owe $100,000, you have $50,000 in equity – or 33%. This means that you still owe 67% of the value of the home (known as Loan-to-Value.)
- Typically, 3Rivers likes to see 20% or more in equity (80% Loan-to-Value) in your home after the Home Equity loan is complete.
- In this scenario, you could expect to receive 13% of the value of your home – or $19,500. This would bring total amount owed to $119,500, which is approximately 80% of the value.
- 3Rivers does offer Home Equity loans up to 90% LTV. So using the same example, you could borrow up to $135,000 total (First Mortgage balance plus the Home Equity loan balance.) This will typically carry a higher interest rate compared to the 80% LTV loan, because less equity is available.
Not for Small Expenses
Home Equity loans are designed for larger expenses. Typically, a Home Equity loan will carry a minimum loan amount of $10,000. So, if you do not need that much money, you may want to opt for another option, such as a personal term loan. Another consideration is to take out a $10,000 HELOC and only borrow what you need.
It is important to remember, however, that even if you only intend to use a portion of the line, you will need to have the 20% equity in your home above and beyond the total amount of the line of credit limit amount.
A Home Equity Loan is a Mortgage Loan
Don’t forget, this is a mortgage loan. It is classified and treated as a loan with interest in the property that is securing the loan from the lender. As with all mortgage loans, there are pluses and minuses to the borrower.
- One downside to a Home Equity loan is that the loan is secured by the home. This means that your home is at risk if you do not make timely payments to fulfill your obligation. The potential consequences include late fees, foreclosure, and a possible judgment. It is important to treat a Home Equity loan with the same importance and attention as you would a First Mortgage loan.
- Because a Home Equity loan is similar to a First Mortgage loan, it also has its advantages. For instance, the rates tend to be lower than rates found on unsecured loan options such as lines of credit, personal term loans, and credit cards. Also, the interest paid on a Home Equity loan is typically tax-deductible. As with any tax situations, we would advise you to consult a tax advisor to give clear guidance on the overall benefits of this feature.
Understand Yourself and Your Spending Habits
It is important to identify your financial picture, habits, and needs before entering into an agreement for any loan, especially one where your home is the collateral.
Take a look at the total amount of debts you pay out each month versus the amount of income you bring in. This will give you a good indication if you are able to comfortably afford an additional payment.
Budgeting for payment on a Closed End Home Equity loan is simple. You will receive the payment amount you will make over a specific period of time. For the HELOC, you will want to budget for 1.5% of the outstanding balance to be paid out each month. This may change depending on the amount actually borrowed as discussed earlier.
Home equity loan options exist to help serve your needs. Our best advice is to make sure you fully research and understand all of your options to determine your best course of action.
This article was co-written with Chris Mulkey, 3Rivers Lending Administrator.