Do you see those commercials saying things like “If you own your own home YOU could qualify for one of our loans” and think “How does that work then?” because I know I do. It turns out that these ads are for home equity loans. But, what exactly is a home equity loan, and, if you need the money, should you consider one? I’m no financial expert, so I spent a bit of time on the internet, and, after plowing through a lot of information, this is what I found out.
What is a home equity loan? A home equity loan can be secured by a borrower who uses the equity of their home as collateral. The amount of the loan can be up to 85% of the property’s current value, minus any outstanding debts held against the home.
That sounds pretty straightforward but I also found out home equity loans have lots of pros and cons. Not only that but there are plenty of hidden costs, hidden risks, and hidden ways that shady lenders can make money at your expense. There is so much more than I first realized.
Home Equity Loans: All You Need To Know
First up is the most important point to consider if you are thinking about a home equity loan. The money for the loan is secured against your house. That means, if you have trouble making the repayments and fall behind, the lender can sell your house to get their money back.
This can happen even if the loan amount is quite small and your house is worth way more than you owe. So be very sure you can afford the repayments before you go any further. Assuming you are confident you can afford a loan, next thing to consider is how much you can, or should, borrow.
Next thing to consider is the size of the loan you can apply for. The value of your house today, minus any loans held against it is your equity and that it what you put up as collateral for the loan.
Let’s imagine you bought your home seven years ago for $300,000 and today it is worth $375,000. To buy your house you took out a mortgage of $250,000 and you have paid $50,000 off of your mortgage. This means you still owe $200,000
The value of your house = $375,000
Outstanding debt = $200,000
Home Equity = $175,000
However, till using this example it does not mean you can get a home equity loan for $175,000. Lenders will usually only give a loan that is equal to a maximum of 85% of your home equity.
Which works out at:
85% of Home Equity $175,000 = Maximum loan available $148,750
Lenders do not always offer the maximum amount available. They will take into account your credit history, their own appraisal of the market value of your home, and your income.
When weighing up your options you also have to take into consideration any fees that you may have to pay during the application process or once your loan is approved.
Home Equity Loan Fees
No two lenders handle the costs involved in granting a home equity home the same way. This makes it impossible to say for certain how much it will cost to take out a loan but the fees usually come to somewhere between 2% and 5% of the loan total.
Some of the fees you might find you have to pay are:
Appraisal fees: The lender will not look at an appraisal by your realtor and just agree that is how much your house is worth. Lenders will ask a professional appraiser to determine the value of your home and work on the basis of their recommendation.
Average appraisal fee: $300-$400
Originator fees: Origination fees are basically the amount a lender charges to process your loan. It is pretty much an application fee and compensates the lender for the time involved in setting up and administering your loan. These fees are usually a percentage of the total loan amount, generally between 0.5 and 1% on loans in the United States.
Some lenders will waive this fee but others will roll in into the loan so you do not have to find the cash upfront but you will have to pay out more interest over the period of the loan.
Title fees: The lender conducts a title search to ensure you are the rightful owner of the property, and if there are any taxes, loans or liens against the home.
Average title fee: $75-$100
Early payoff fee: Some lenders will require you to have the loan for a minimum period of time, usually three years. They may charge a cancellation fee if you try to save interest costs and pay it off early.
Annual or membership fee: This may be charged if you do not already hold any financial products with the lender.
Lawyer or document preparation fee: A lawyer or financial expert will prepare the legal documents for the loan. Again, some institutions will waive this fee.
The Benefits Of A Home Equity Loan
A home equity loan can allow you to borrow a larger amount of money than you might otherwise be able to have with an unsecured loan. They also tend to have longer repayment terms available so the monthly amount you have to pay back can be more manageable.
Home equity loans also have a fixed interest rate so you know exactly how much your monthly repayment will be without fear of it fluctuating. This rate is likely to be lower than credit card rates and the interest on unsecured loans.
Borrowing through a home equity loan also offers flexibility. You can use the money for anything you want.
The Downside Of Home Equity Loans
By taking out a home equity loan you are putting your house up as collateral so if there are any unforeseen circumstances that prevent you from making payments the lender can force the sale of your house in order to recoup their money.
If you have a home equity loan and the housing market tanks, you may be left with a loan that is more than the value of your house.
It can be easy to borrow more than you need, especially if your lender has a minimum size limit in place for home equity loans.
You can find yourself with a never-ending debt. Many people get into a cycle of taking out a home equity loan, paying off a percentage of the loan, and then taking out a new loan to pay off the first plus receive a new lump sum.
How Does A Home Equity Loan Differ From A Home Equity Line Of Credit?
When you are looking for a home equity loan you may also come across home equity lines of credit and wonder “what’s the difference?”
First of all, it is easier to look at the elements that are the same. Both a home equity loan and a home equity line of credit allow you to:
- Borrow money using the equity of your house as collateral.
- Use the money you borrow for whatever you like.
The differences are that with a loan you are given a fixed sum of money and agree to pay it back over a set period of time. A home equity line of credit works more like a credit card secured against your house. You have a borrowing limit, use what you borrow for whatever you like and pay it back with minimum payments that change according to your outstanding debt.
What Can You Use A Home Equity Loan For?
One of the biggest advantages of a home equity loan is that you can use the money for anything you like. Many people choose to use it to make home improvements or to finance major repairs, damage caused by natural disasters etc.
Meanwhile, other people will take out a home equity loan to pay off medical bills or pay for their child’s education.
Others will use the equity in their house to fund luxury items such as an expensive holiday, new vehicles, or a second or holiday home.
Update:From the 2018 tax year onwards, you have to show evidence that you have used your home equity loan for improvements to your property if you want to claim the interest on the loan as a tax deduction.Read “Does Buying A House Help With Taxes?” for the details.
What Should I Look Out For?
There are unscrupulous lenders out there and they are most likely to target the elderly, the sick, and those with low incomes or credit issues. When choosing a lender look out for:
- Loan Flipping: You are encouraged to refinance your loan over and over, paying more fees each time, increasing your debt.
- Equity Stripping: The lender encourages you to take a loan for the full amount of equity in your home then waits for you to default and buys your home for a reduced amount.
- Improper fees: Some lenders will throw in all kinds of frivolous fees that you only find out about after you have signed and you are then liable for them.
- Insurance packing: A lender might insist that you have to buy insurance products from them or a company connected to them, that you do not really need.
- Lower monthly payments: Some loans are structured so that you have a lower monthly payment but then a huge final payment at the end of the loan.
- Variable interest rates: Some unscrupulous lenders may offer a variable interest rate and a low repayment amount that is not enough to cover the interest on the loan. This way you get further into debt and are never able to pay off the loan.
As you can see there are pros and cons of to taking out a home equity loan. However, if you are sensible and careful, it can be an excellent way to pay for large expenses without incurring huge interest payments.
About The Author
Geoff Southworth is the creator of RealEstateInfoGuide.com, the site that helps new homeowners, investors, and homeowners-to-be successfully navigate the complex world of property ownership. Geoff is a real estate investor of 8 years has had experience as a manager of a debt-free, private real estate equity fund, as well as a Registered Nurse in Emergency Trauma and Cardiac Cath Lab Care. As a result, he has developed a unique “people first, business second” approach to real estate.
This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policy.