How does a home equity loan work? First, it’s important to understand that the term home equity loan is simply a catchall for the different ways the equity in your home can be used to access cash. The most common types of home equity loans are fixed-rate home equity loans, home equity lines of credit (HELOCs), and cash-out refinancing.
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What Are the Main Types of Home Equity Loans?
When folks think of home equity loans, they typically think of either a fixed-rate home equity loan or a home equity line of credit (HELOC). There is a third way to use home equity to access cash, and that’s through a cash-out refinance.
With fixed-rate home equity loans or HELOCs, the primary benefit is that the borrower may qualify for a better interest rate using their home as collateral than by using an unsecured loan—a loan that is not backed by collateral. Some people with high-interest credit card debt may choose to use a lower-rate home equity loan to pay off those credit card balances.
This does not come without its risks, of course. Borrowing against a home could leave it vulnerable to foreclosure if the borrower is unable to pay back the loan. A personal loan may be a better fit if the borrower doesn’t want to put their home up as collateral.
How much a homeowner can borrow is typically based on the combined loan-to-value ratio (CLTV ratio) of the first mortgage plus the home equity loan. Generally, this figure cannot exceed 80% CLTV. To calculate the CLTV, divide the combined value of the two loans by the appraised value of the home. In addition, utilizing a home affordability calculator can be a good starting point in understanding how much you will need to put down and other expenses related to the first time home buying process.
Of course, qualifying for a home equity loan is typically contingent on several factors, such as the credit score and financial standing of the borrower.
Fixed-rate Home Equity Loans
Fixed-rate loans are pretty straightforward: The lender provides one lump-sum payment to the borrower, which is to be repaid over a period of time with a set interest rate. Both the monthly payment and interest rate remain the same over the life of the loan. Fixed-rate home equity loans typically have terms that run from five to 15 years and must be paid back in full if the home is sold.
With a fixed-rate home equity loan, the amount of closing costs is usually similar to the costs of closing on a home mortgage. When shopping around for rates, asking about the lender’s closing costs and all other third-party costs is recommended. These costs vary from bank to bank.
This loan type may be best for borrowers with a one-time or straightforward cash need. For example, a borrower wants to build a $20,000 garage addition and pay off a $4,000 medical bill. A $24,000 lump sum loan is made to the borrower who would then simply pay back the loan with interest. This option could also make sense for borrowers who already have a mortgage with a low-interest rate and may not want to refinance that loan.
Recommended: What Is a Fixed-Rate Mortgage?
Home Equity Line of Credit (HELOC)
A HELOC is revolving debt, which means that as the loan balance is paid down, it can be borrowed again during the draw period (whereas a home equity loan provides one lump sum and that’s it). For example, a borrower is approved for a $10,000 HELOC. They first borrow $7,000 against the line of credit, leaving a balance of $3,000 they can draw against. The borrower then pays $5,000 toward the principal, which gives them $8,000 in available credit.
Unlike with a fixed-rate loan, a HELOC’s interest rate is variable and will fluctuate with market rates, which means that rates could increase throughout the duration of the credit line. The monthly loan payments will vary because they’re dependent on the amount borrowed and the current interest rate.
HELOCs have two periods of time that are important for borrowers to be aware of: the draw period and the repayment period.
• The draw period is the amount of time the borrower is allowed to use, or draw, funds against the line of credit, commonly 10 years. After this amount of time, the borrower can no longer draw against the funds available.
• The repayment period is the amount of time the borrower has to repay the loan in full. The repayment period is for a certain number of years after the draw period ends.
A 30-year HELOC will have a draw period of 10 years and a repayment period of 20 years. Payments made during the draw period are typically interest only, with principal payments added during the repayment period.
This loan type may be best for people who want the flexibility to pay as they go. For an ongoing project that will need the money portioned out over longer periods of time, a HELOC might be the best option. While home improvement projects might be the most common reason for considering a HELOC, other uses might be for wedding costs or business start-up costs.
Recommended: How Do Home Equity Lines of Credit Work?
Home Equity Loan Fees
Generally, fees should be disclosed by the lender, under federal law, although there are some fees that are not required to be disclosed. Borrowers certainly have the right to ask what those undisclosed fees are, though. Fees that require disclosure include application fees, points, annual account fees, and transaction fees, to name a few. Lenders are not required to disclose fees for things like photocopying related to the loan, returned check or stop payment fees, and others.
Home Equity Loan Tax Deductibility
Since enactment of the Tax Cuts and Jobs Act of 2017, interest on home equity loans is only deductible if the loan is used on qualifying home improvements. Checking with a tax professional to understand how a home equity loan or HELOC might affect a certain financial situation is recommended.
Mortgage refinancing is the process of paying off an existing mortgage loan with a new loan from either the current lender or a new lender. Common reasons for refinancing a mortgage include securing a lower interest rate, or increasing or decreasing the term of the mortgage. It may be worth comparing rates and terms from multiple lenders. Depending on the new loan’s interest rate and term, the borrower may be able to save money in the long term. Increasing the term of the loan may not save money on interest, even if the borrower receives a lower interest rate, but it could lower the monthly payments.
With a cash-out refinance, a borrower may be able to refinance their current mortgage for more than they currently owe and then take the difference in cash. For example, a borrower owns a home with an appraised value of $400,000 and owes $200,000 on the mortgage. They would like to make $30,000 worth of repairs to their home, so they refinance with a $230,000 mortgage, taking the difference in cash.
As with home equity loans, there typically are some costs associated with a cash-out refinance. Generally, a refinance will have higher closing costs than a home equity loan.
This loan type may be best for people who would prefer to have one consolidated loan and may want to secure a lower rate or different loan term. For example, a homeowner who purchased their house 10 years ago with a 6% mortgage interest rate may now have equity in the home and might even have better credit than when they first took out the mortgage. The homeowner might be able to refinance to a mortgage with a 4% interest rate while also taking out cash.
Traditional mortgages are often referred to as “first mortgages,” and home equity loans are often referred to as “second mortgages.” In both cases, a bank or other creditor loans money to the borrower, using real property as collateral. Both also require a review of the borrower’s financial situation to determine a loan rate, and both options come with a similar set of fees. Cash-out refinancing is not taking out a second mortgage—it’s getting a new first mortgage.
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