Understanding Home Equity Loans

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Real Estate

If you’re planning to expand your home or fund a project, a home equity loan could be the solution. Learn more about this type of loan and how it works.
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Imagine you’re starting a family and your current home is too small. You want to add a nursery or expand your kitchen, but you don’t have the funds for the renovations. This is where a home equity loan comes in. This article will explain what it means to borrow against the equity of your home, the different types of home equity loans available, and when it may be the right choice for you.

In the next section, we’ll cover some of the basics of home equity borrowing.

 

Basics of Home Equity Borrowing


If you’re looking to finance a home renovation or remodel, a second mortgage or home equity loan may be a good option.
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There are several types of loans that allow you to use the equity in your home as collateral. The more traditional option is a home equity loan, also known as a second mortgage. With this type of loan, you receive a lump sum of money from the bank and are required to pay it back over a fixed period of time with an established interest rate. If you have a specific project in mind, like a renovation or remodel, a second mortgage might be the right choice.

Now that you know the basics of home equity borrowing, let’s take a closer look at equity itself.

Understanding Equity

Borrowers have a few options when it comes to borrowing against the equity of their home, including a home equity loan, a home equity credit line (HELOC), and a reverse mortgage. A home equity loan or second mortgage is based on the equity you have in your home. Equity is the difference between the current value of your home and the amount you owe on your initial mortgage. For example, if you bought your home for $350,000 and have paid off $175,000 of a $300,000 mortgage, and a recent appraisal values your home at $500,000, your current equity would be:

$500,000 minus $125,000 equals $375,000

The remaining balance of your mortgage is $125,000. However, as your home’s value has increased, so has your equity. Your equity can be used to obtain a second loan, with your home serving as collateral. If you are unable to pay off the second mortgage, you may be forced to sell your home or have it seized by the bank. Second mortgages typically have a shorter term and lower amount than the first mortgage, and are often used for consolidating debts or financing home improvements or education. However, some homeowners use the rising equity of their home to gain financial flexibility.

The increase in home ownership in the US has led to an increase in mortgage debt.

Home Equity Loans and Reverse Mortgages

A home equity loan is ideal for obtaining a specific amount of money for a project or investment. This type of loan involves borrowing against the equity in your home and is commonly referred to as a second mortgage. The loan comes in a fixed amount that is repaid over a set period of time. The interest on a home equity loan may be tax deductible up to $100,000.

A Home Equity Credit Line (HELOC) also uses the borrower’s home as collateral. This works like a credit card, with the lender setting a credit limit based on various factors. The borrower can draw money using checks, electronic transfers, or a credit card within a specific period of time. After this period, the borrower must either renew the credit line or repay the debt over another fixed period of time. Alternatively, the outstanding debt can be rolled into a traditional loan.

When choosing a home equity credit line, it is important to select one that meets your specific needs because the terms of these plans can vary. You should consider the annual percentage rate (APR) and other costs of the plan. A home equity plan can come with many fees, including an application fee, property appraisal, attorney’s fees, title search, mortgage preparation and filing fees, property and title insurance, taxes, membership or maintenance fees, and transaction fees. The structure of the drawing and repayment periods should also be carefully considered. If you need money in installments, a home equity line of credit can be a good option. However, if you are concerned that the flexibility offered by a line of credit will lead to excessive spending, it may not be the right loan for you.

A reverse mortgage can provide money that you may not have to repay for the rest of your life, but there are conditions attached to it. To be eligible for a reverse mortgage, you must be at least 62 years old and live in the home for at least 50% of the year. You also need to be the owner of the home. While you may not have to repay the loan if you maintain the reverse mortgage until you pass away, your heirs will have to pay it off if they wish to keep the house. Unlike a traditional mortgage, a reverse mortgage involves rising debt and falling equity.


If you have retired and have an eye on something you want to buy, such as a boat, a reverse mortgage could help you realize your goal. However, it is important to note that the loan will eventually need to be repaid by someone.
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Out of all the different types of reverse mortgages, only the Home Equity Conversion Mortgage (HECM) is federally insured. The HECM program sets limits on loan costs and informs the lender about how much they are allowed to lend you. This type of mortgage is often cheaper than other reverse mortgages. Usually, only reverse mortgages offered by state and local governments are cheaper than an HECM. However, these mortgages are mostly available to those in lower income brackets and need to be used for specific purposes. If you want to find out how much you could receive from an HECM or a Home Keeper Mortgage from Fannie Mae, use a mortgage calculator.

Consider This!

Before deciding to take out a reverse mortgage, it is important to consider whether it is worth it. Many people do not want to sell their homes, whether for sentimental reasons or because of the work associated with moving, when faced with debt or significant expenses in their retirement years. However, it is important to calculate how much money you could get from selling your home and compare that to how much it would cost to buy and maintain (or rent) a new home. Ultimately, moving to a smaller or more easily maintained home may be more financially beneficial (and help your heirs in the future) than taking out a reverse mortgage. The extra capital from selling your home and moving to a smaller place could supplement your retirement income and remove the need for a reverse mortgage. For more information about housing options, visit the AARP website. There may be more choices than you think.

Read the Fine Print

Taking out a home equity loan puts your home at risk. Therefore, it is important to ensure that you can afford the terms and conditions of the loan agreement.
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In 1968, the United States Congress passed the Consumer Credit Protection Act, which is also known as the Truth in Lending Act. This act was created to protect consumers from unfair loan agreements. According to the act’s provisions, a lender must disclose important terms and costs of home equity plans, APR, payment terms, information about variable rates, and any other miscellaneous charges. The act also allows consumers three business days to cancel the agreement after the account is opened. If the borrower does cancel the loan, they must inform the creditor in writing, and the creditor must cancel their security interest in the borrower’s home and return all application and loan fees.

The Consumer Credit Protection Act is especially important for people seeking second mortgages who may be in difficult or desperate financial conditions. Some unscrupulous lenders may try to take advantage of them by offering terms that they cannot afford or secretly changing aspects of the loan agreement.

If the three-business day cancellation period passes and you feel that you have been taken advantage of, report your lender to the Federal Trade Commission. You can also contact consumer protection agencies, housing counseling agencies, or your state bar association for a referral to a lawyer.

Differences and Similarities

A home equity loan has a fixed interest rate, providing the borrower with a known monthly payment. On the other hand, a home equity line of credit typically has a variable interest rate based on public indexes, which means that the borrower may face uncertainty regarding their monthly payment. However, this type of loan offers the flexibility of paying interest only or interest and some of the principal.

The interest rates for a variable rate plan are determined by the prime rate or the U.S. Treasury Bill (“T-Bill”) rate, and will change as these rates change. A variable rate plan has a cap on how high the rate can go during the term of the plan, and some have limits on how much the interest rate can decrease. These rates are affected by the Fed’s decision to raise or lower interest rates. Note that many lenders add a margin to their interest rates, typically measured in points.

Some lenders may allow borrowers to convert from a variable rate to a fixed-rate during the home equity plan, or to convert some or all of their debt to a fixed-term installment plan. However, some lenders may not allow borrowers to withdraw money when the interest rate reaches the pre-established cap.

Repayment and Some Tips

The repayment process for a home equity loan or a home equity line of credit depends on the terms of the plan. Some equity plans only require payment of interest during the loan, leaving the entire principal to be paid once the loan is due.

If the payment schedule of the plan leaves a remaining balance at the end of the term, borrowers should be prepared to make a balloon payment. This can be done with money on hand, by refinancing the loan, or by taking out a loan from another lender. Failure to pay a balloon payment can lead to loss of the borrower’s home.

Most payment options are flexible, allowing borrowers to pay more than the minimum payment. Many home equity borrowers make regular payments to the principal to avoid being stuck with an outstanding balance when the loan is due. If the borrower decides to sell their home before the end of the plan, they will likely have to repay the equity loan.

Tips for Equity Plans

Before obtaining a home equity loan or HELOC, consider your ability to handle more debt. Are you in a stable job and able to repay the loan in the future? If you are facing financial difficulties, seek help from a credit counseling agency. If you are struggling with your mortgage payments, you can get a list of approved housing counseling agencies from the Department of Housing and Urban Development. It is advisable to get a home equity loan when you have a specific purpose in mind. A home equity line of credit offers more flexibility than a home equity loan, but using it like a regular credit card can lead to problems.

When you have decided to get a home equity loan, it is crucial to shop around. Make sure to deal with reputable lenders as predatory lenders take advantage of vulnerable people. Ask for recommendations from friends and family and research the lenders’ reputations.

Due to various fees and variable interest rates, comparing loans can be challenging. The FDIC worksheet can help you compare loan offers and ask relevant questions to keep track of each lender’s information.

Negotiate with prospective lenders and ask for lower rates, fees, and points. Let them know that you are shopping around, and make them beat the terms of other lenders.

After selecting a lender, ask for a “good faith estimate” of all charges. By law, the lender has to provide an estimate within three days of your application. Review the forms and ask questions. A week before closing, ask if the terms have changed from the estimate.

If you know someone with loan experience, have them review the estimate, loan papers, and contract. Ask any questions you may have and do not sign anything you are unsure of or contains blank fields. If your lender tells you blank fields are supposed to be empty, draw a line through it and initial it.

When taking out a loan, it is essential not to borrow more than you require or for terms that are unaffordable. Even if the lender assures you that the terms are favorable, it is best to avoid a high loan-to-value ratio, as it could make loan repayment difficult and put your home ownership at risk. The loan-to-value ratio is calculated by dividing what you owe on your house by its overall value. Lenders typically aim to keep your loan-to-value ratio below 80 percent. For instance, if you owe $250,000 on a $500,000 house, your loan-to-value ratio is 50 percent. For a second mortgage, a lender will not provide you with more than $150,000, which would result in a loan-to-value ratio of 80 percent ($400,000 divided by $500,000). Avoid loans that exceed 80% or offer more than your property is worth. Such loans will usually carry higher interest rates, require mortgage insurance, and be more challenging to repay if you have to sell your home. To learn more about home equity loans and related topics, visit the links on the following page.

FAQ on Home Equity Loans

What is a home equity loan and how does it function?
A home equity loan, otherwise known as a second mortgage, allows you to borrow against the equity of your home. Similar to a regular mortgage, you receive a lump sum of money from the lender, which you must pay back over a fixed period of time at a specific interest rate.

What is the maximum amount you can borrow on a home equity loan?
Typically, lenders will let you borrow up to 80 to 90% of your available equity, based on your credit score, income, and the lender’s policies. For example, if your home is worth $500,000 and you have $125,000 left to pay on a $300,000 mortgage, your equity in the house is $375,000. Your lender will decide the percentage of this amount that you can borrow.

Which is better, a home equity loan or line of credit?
A home equity loan is best if you prefer fixed monthly repayments and need a specific amount for a particular goal or home improvement project. On the other hand, a home equity line of credit is better if you require flexible access to funds over time. The terms and conditions of these credit lines vary, so it’s essential to research and choose one that suits your needs.

What are the possible uses of a home equity loan?
Although you can legally use a home equity loan for anything, most people use them for significant expenses such as home renovations, medical bills, or education costs.

What is the average interest rate on a home equity loan?
The interest rate you receive depends on your circumstances and the current market rate.

More Information

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Sources

The following is a list of web resources relating to reverse mortgages, home equity loans, and other borrowing options for seniors and homeowners. The list includes links to articles and guides from various sources such as AARP, the U.S. Department of Housing and Urban Development, Motley Fool, Bankrate.com, and more. Topics covered include the basics of reverse mortgages, risks associated with borrowing against one’s home, the differences between home equity loans and lines of credit, and loan-to-value ratios. The list also includes a definition of U.S. Treasury Bills.

FAQ

1. What is a home equity loan?

A home equity loan is a type of loan where a borrower uses the equity in their home as collateral. The equity is the difference between the home’s current value and the outstanding mortgage balance. The loan is typically a lump sum that is paid back over a fixed term with a fixed interest rate.

2. How does a home equity loan differ from a home equity line of credit?

A home equity loan is a lump sum that is paid back over a fixed term, whereas a home equity line of credit (HELOC) is a revolving line of credit that can be used as needed and paid back over time. HELOCs typically have variable interest rates.

3. How much can I borrow with a home equity loan?

The amount you can borrow with a home equity loan is typically based on a percentage of your home’s equity, which can vary by lender. Generally, lenders will allow you to borrow up to 80% of your home’s equity.

4. What can I use a home equity loan for?

You can use a home equity loan for a variety of purposes, such as home improvements, debt consolidation, or other major expenses. Some lenders may have restrictions on the use of funds, so it’s important to check with your lender.

5. How do I qualify for a home equity loan?

To qualify for a home equity loan, you typically need to have a good credit score, a low debt-to-income ratio, and enough equity in your home. Lenders may also consider your income and employment history.

6. How long does it take to get a home equity loan?

The time it takes to get a home equity loan can vary by lender, but typically it takes several weeks from application to closing. Some lenders may offer faster turnaround times.

7. What fees are associated with a home equity loan?

There may be fees associated with a home equity loan, such as an origination fee, appraisal fee, and closing costs. It’s important to understand all the fees and costs associated with the loan before applying.

8. What happens if I can’t make payments on my home equity loan?

If you can’t make payments on your home equity loan, the lender may foreclose on your home to recoup their losses. It’s important to make sure you can afford the loan before applying.

9. Can I refinance my home equity loan?

Yes, you can refinance your home equity loan if you can find a lender who is willing to offer better terms. However, it’s important to weigh the costs and benefits before refinancing.

10. Are there tax benefits to a home equity loan?

In some cases, the interest paid on a home equity loan may be tax deductible. However, the rules around tax deductions for home equity loans have changed in recent years, so it’s important to consult a tax professional for advice.

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