When you own a home, it’s probably the greatest commodity for your name. This value can be used for you as collateral on a loan that you can use for any purpose from renovations to paying for emergencies.
That’s the gist of a home loan: money that you borrow against the value of your home.
Here’s what you should know about home equity loans, and how they work.
What is a Home Equity Loan?
“A home equity loan is a loan where a homeowner can borrow money from a bank and the equity in their home is used as collateral for the loan,” says Elliott Pepper, CPA, CFP and co-founder of Northbrook Financial .
How does a home loan work?
There are two basic forms of borrowing against the value of your home: a home equity loan or a home equity line of credit, also known as a HELOC. The two should not be confused. A home equity loan pays you a lump sum; With a HELOC, you have a line of credit up to a predefined maximum amount that you can use for high expenses or debt consolidation.
When considering a home loan, keep in mind that if you stop paying the debt, the lender may repossess it since your home is used as collateral.
How to Calculate Home Equity
Home equity is simply the difference between the value of your home – how much it could sell today – and what you owe on the mortgage. If you have a $ 100,000 mortgage on a $ 300,000 home, your home equity is $ 200,000. If you own your home freely and without a mortgage, then all of its worth is your home equity.
How To Use Home Loans
You can use a home loan for almost anything – it doesn’t have to be home related. However, the loan is tax deductible if you use the funds to improve your home significantly, as well as if the total debt associated with the home does not exceed $ 750,000. This includes any other mortgage and / or home loan.
Types of Home Loans
There are three main types of home loan. Let’s take a closer look at them.
Fixed rate home equity loans
A fixed rate home loan is a lump sum that is paid out to you at a fixed rate over time. That makes it an attractive option for large, one-time expenses such as B. a new roof or the financing of a large-scale home renovation.
The more equity you have in your home, the more you can borrow, usually up to 85% of that equity. Home equity is the current value of your home minus what you owe on your mortgage.
Home Equity Line (HELOC)
A HELOC is a line of credit with a variable interest rate. You receive a credit up to a predefined maximum amount, similar to a credit card.
You can use this loan for expenses such as home renovations or to consolidate higher interest debt. Since the credit line is available over a long period of time – a typical term is 25 years – this is a good way of financing ongoing residential projects; it can also be a source of funding for future needs that may arise.
Cash-out refinancing
With a payout refinance, you pay off your existing home loan and receive a new one that is greater than your debt. You will then receive a check for the price difference.
How To Qualify For A Home Loan
To qualify for a home loan, you should meet the following requirements:
- A credit score over 680
- At least 15% equity in your home
- Lending ratio of 80% or less
- Sufficient income
- Reliable payment history
Your creditworthiness plays an important role in not only determining whether you can get a loan, but also what your interest rate will be.
“A common starting point for being eligible for a home loan is 680, but the higher the credit, the lower the interest rate,” says Pepper. (This is how you can check your creditworthiness for free.)
Home loans have a significantly lower annual percentage rate (APR) than unsecured loans such as credit cards because they provide security to the lender in the form of collateral.
As of May 2021, the average interest rate on a home loan is around 5.26%, according to data from Bankrate (which shares an owner with NextAdvisor). With good credit, you can get a home loan with an APR of less than 4%, says Pepper. Since interest rates are currently low, you have good credit, and the interest rate on a loan you are applying is no less than 4%, “something is probably going on,” says Ford.
Most home equity loans have a term of five to 30 years.
The more equity you have in your home, the more you can borrow; In general, you can borrow up to 85% of the equity in your home depending on how good your credit is and how much other debts you have, says the Federal Trade Commission.
An important key figure in this context is the loan-to-value ratio. Lenders will consider borrowers cheaper with a lower rate and give them lower interest rates when all else is the same. Often times the maximum allowable is 80%, which means that the balance of the mortgage should not be more than 80% of the current value of the house.
Paying back a home loan is similar to paying back your mortgage: you have a fixed annual percentage and you make monthly payments over the life of the loan.
Borrowers can deduct the interest they pay on a home loan from their taxes like a mortgage, but there are some restrictions.
For loans taken after December 15, 2017, “taxpayers can only deduct interest on qualifying loans of up to $ 750,000 – this includes the value of your current mortgage and home loan,” says Pepper. “Also, the proceeds from the home loan must be used to build or significantly improve your home.”
It also points out that it is an individual deduction, which means that depending on your circumstances, you may be better off applying the standard deduction and therefore not deducting any home equity interest at all.
Where can you apply for a home loan
If you are considering getting a home loan, the first thing to do is do your research and compare the offers from different lenders.
Pro tip
There can be a lot of value stored in your home, but look around before tapping into it with a home loan.
“Most major banks and financial institutions offer home equity loans, so it is always a good idea to get a few quotes and compare terms, particularly the interest rate and other fees, to make sure you are getting the right loan for you,” says Pepper.
A good starting point is the bank of which you are already a customer. You may even need to have an account with the bank in order to get a home loan from it. Working with your existing bank could also bring you a lower interest rate, says Russ Ford, financial planner and founder of Wayfinder Financial.
Who Should Consider A Home Loan?
Taking out a loan against the value of your home is something to consider “when you have to pay for something but you don’t have the money to do it,” says Michael Caligiuri, CFP, Founder and CEO of Caligiuri Financial.
One of the most common reasons for getting a home loan is for home remodeling and home improvements. “Taking out a relatively low-interest loan, especially if it is meant to cover the cost of a major home improvement or renovation, could be a smart financial move,” says Pepper. Because the improvements or renovations can increase the value of your home in the long term and lead to a better quality of life.
However, home improvement projects – like painting, laying new floors, or even swapping out your equipment for new ones – are not the only possible uses of these loans.
Home loans can also be used to pay college bills or pay back higher-interest debt, says Lindsay Martinez, CFP who owns financial planning firm Xennial Planning in San Juan, Puerto Rico. But be careful: you would be borrowing against your home to pay off unsecured, or unsecured, debt. “You shouldn’t take out a home equity loan for personal expenses like a boat or a canceled vacation,” she advises.
However, taking out a home loan can be a way to access a tremendous resource of value and make good use of it, especially at a time – during the coronavirus pandemic-induced recession – when people are in dire economic straits.
“A lot of people are very stressed from a liquidity perspective and their only real option might be to get a fixed rate home equity loan,” said Michael Caligiuri, CFP, founder and CEO of Caligiuri Financial.
Bottom line
Obtaining a home loan is not an easy decision, but it can be a financial lifeline in certain situations. Most borrowers use the money on home improvement projects that can add value over the long term, but there are several other ways to use a home loan. Just make sure you do a thorough research before committing to one as you are also agreeing to mortgage your home as collateral.
