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What is a home equity loan?
A home equity loan, also called a second mortgage, or a home equity installment loan, is a consumer loan allowing borrowers to take out a loan against the real estate's equity.
The amount of this type of loan depends on the difference between the real price of real estate on the market and the current mortgage balance of the borrower.
There are two types of home equity loans. These are home equity loans with fixed interest rates and home equity line of credit (HELOC), which has variable rates. Fixed-rate equity loan allows to borrow money once, and a home equity line of credit comes with a revolving line of credit.
How does home equity loan work?
Another name for a home equity loan is the second mortgage, since the basic principles of these types of loans are similar. In a home equity loan, the borrower's real estate is collateral for a bank, lender, or other financial institution. The property is transferred to the lender's ownership if the borrower cannot repay the loan. The lender will sell the property and will not lose profit. The loan amount is calculated partly from the combined loan-to-value (CLTV) ratio of 80% to 90% of the real estate's estimated value. Also, the available loan amount for the borrower is affected by their credit score and payment behavior when mortgaging or renting housing. A home equity loan with a fixed rate has a certain repayment term, just like a traditional mortgage. The borrower must pay fixed monthly payments, which consist of principal and interest.
Home equity lines of credit are an alternative to home equity loans that allow the borrower to get revolving lines of credit. The borrower takes a certain amount according to his credit limit, returns it, and can take a new amount. The draw period most often ranges from 5 to 10 years. After this period, there comes a repayment period of 10 to 20 years in length, during which it is impossible to withdraw money. Usually, HELOC has a variable rate, but some lenders may offer a home equity line of credit with a fixed interest rate.
Home equity loans and HELOCs allow the borrower to convert the home's equity into cash to cover various bills. This loan option is ideal for paying for home renovations and installation improvements, as it increases the house's value on the market. The borrower can also use the amount received from the home equity loan for other purposes. For example, close credit card, medical, or college bills. Also, the borrower can make a debt consolidation.
However, the borrower should remember that this type of loan is quite risky. A home equity loan should be considered as the last option to find the right amount of money in an emergency, since the borrower risks losing the house if they have problems with work, for example. If the borrower used home equity to pay for another loan, then they should not take out a new loan since the home equity loan's repayment term can reach up to 30 years.
Pros and cons of home equity loans
Pros
A home equity loan is easy enough to get, and this loan is secured, and therefore lenders do not have such high requirements for borrowers as, for example, for borrowers who take other consumer loans. The lender makes a credit check and orders an appraisal of the borrower's home to check the credit score and CLTV ratio.
A home equity loan is an easy way to get a large amount of money. Other personal loans have a low maximum limit on the amount a borrower can take. This loan is suitable for those borrowers who need a large amount at once and have a stable source of income in which they are confident.
Average home equity loan rates are 5.82%, 5.60%, 5.28%, and 5.61% for 15-year, 10-year, and 5-year fixed-rate loans and HELOC, respectively. These indicators are sometimes equal or even less than the mortgage interest rates. Moreover, such interest rates are much lower than other consumer loans such as credit cards or payday loans.
Cons
Because it is easy to get a home equity loan and the borrower receives a large lump sum amount, some borrowers may fall into even greater debts. The first reason homeowners take out such a loan is to close other loans, such as credit card debt. After closing such a loan, the borrower still has considerable money. The borrower gets into a loan and closing cycle, and as a result, the home equity loan remains in even greater debt at the end of his life.
Getting into even bigger debts provokes some borrowers to take a special home equity loan offering 125% of the property's value. Such a loan most often has an increased interest rate. Since the amount issued to the borrower is more than the amount of the real estate value, not the entire loan amount is secured by collateral in the form of real estate. Moreover, the interest the borrower paid on top of the cost of the house cannot be tax deductible.
Taking a home equity loan is a risky move on the borrower's part regarding real estate ownership. This loan option has a very long loan term during which anything can happen to the borrower's source of income, for example, dismissal or business decline. By taking out such a loan, the borrower risks losing real estate that, for example, was taken on a mortgage, and the payment of this mortgage was a long and costly process. Also, the borrower should know that if the loan is not paid in full, it will cause damage to the credit history, and loss of real estate can lead to bankruptcy.
Taking a home equity loan may close the borrower's access to other loans for the lifetime of this loan. Having a loan with such a large amount and such a long repayment term will reduce the trust of lenders in the borrower. For the entire loan term, which can be 30 years, the borrower will most likely not be able to get any other serious loan.
Conclusion
A home equity loan is suitable for borrowers who know exactly what they need an outstanding loan balance for. The borrower should weigh all the risks, of which there are many. This loan is not recommended for borrowers who often use credit cards and plan to take out any other loan in the next 10 to 30 years. Also, a home equity loan is not recommended for borrowers without a permanent source of income in which they are confident, as this is a big risk of losing the house.
How to get a home equity loan
Since home equity loans and home equity lines of credit are secured loans, most home equity lenders set lax credit requirements for borrowers.
Before applying for a home equity loan, the borrower must check their debt-to-income ratio and credit score. To obtain this loan option, the borrower must have a debt-to-income ratio of no more than 45%. Also, lenders usually require at least 600 to 620 credit scores. Also, a mandatory requirement for the borrower's credit history is not the presence of bankruptcies over the past 7 years, on-time mortgage payments, or rental housing. The borrower may not meet these criteria and receive a home equity loan, but in this case, the homeowner will have a high-interest rate as he will be a risky borrower for the lender.
The borrower must provide provable employment or another stable source of income that brings the borrower an income for a minimum of 2 years. Also, equity in their home should be greater than 20% of their value.
Modern second mortgage lender offers potential borrowers the process of obtaining a home equity loan online. To do this, the homeowner needs to go to the lender's website and click on the "Get Started" or "Apply Now" button. Next, the borrower needs to enter the zip code of their real estate address. On the first page of the application form, the borrower must fill in personal information such as name, phone number, email, marital status, SSN, and residential address. On the next page, the homeowner needs to enter information about employment or another source of income. They need to enter information such as the employer's name, phone number, and the amount of the term of employment. Next, the borrower needs to enter information about their real estate, namely the type of real estate, cost, ownership status, and location address. The application is completed in 10 minutes if all the necessary information is available. The credit approval comes to the borrower within a couple of hours.
The lender can request the download of these documents to confirm identity, employment, and income level:
Driver's license or state-issued ID
W-2 forms
1099s
Tax returns
Pay stubs.
Ways to pay home equity loan back
Every borrower wants to repay the loan in full and in a short time. There are several ways to quickly close home equity loans or home equity lines of credit.
Learn the fees
Before signing a loan agreement, the borrower needs to pay attention to additional fees that can be added to monthly payments. These can be origination fees, prepayment, property insurance, homeowners insurance, and closing costs. In addition to studying additional fees, the borrower needs to study whether the interest they will pay at the end of the life of the loan is tax deductible, as this will significantly reduce the costs of home equity loans.
Make an additional payment
After the borrower has calculated their equal monthly payments, they need to calculate their budget to make an additional monthly payment at least once a year. An additional monthly payment will allow the borrower to reduce the loan term, thereby reducing the interest they have to pay.
Set automatic payments
Automatic loan repayments can be installed on the lender's website. These payments are made every month automatically from the checking or savings account of the borrower using ACH debit. Automatic payments allow the borrower not to be late with payments, thereby avoiding the commission for late payments.
Aim to refinance home equity loans
Refinancing home equity loans is a good way to lower the interest rate and reduce the loan term. The borrower should look for different refinancing options from credit unions, banks, and online lenders.
Do not use all cash from credit line in HELOC
The borrower who took HELOC has to pay interest for every amount they withdrew from the line of credit. To reduce interest and quickly pay off HELOC, the borrower is recommended to use only about 20% of the credit limit.
Legal regulations
Federal Reserve Consumer, Consumer Financial Protection Bureau, and Federal Deposit Insurance Corporation (FDIC) regulate the issuance, payment, and other processes related to home equity loans.
Among the federal laws, it is possible to distinguish several legal acts. This is the Truth in Lending Act (TILA) which regulates the sale of loans, and the Real Estate Settlement Procedures Act, which regulates that buyers and sellers are given disclosures about the full settlement costs related to home buying.
Also, the borrower should pay attention to the addition of the Equal Housing Lender to the name of the lender since this addition means that the lender does not discriminate against borrowers on any basis.