Eventually, you will need money that you don’t presently have on hand. Whether that unexpected expense is large or small, one option for homeowners may be a home equity loan. Basically, a home equity loan is a second mortgage. The originally mortgage pays for the home, and the second can be used for another need.
“Home equity lending is making something of a comeback. After being nearly shut down with the collapse of housing prices during the Great Recession, lenders are once again opening up their wallets and allowing people to borrow against the value of their homes.”
—Kirk Haverkamp, Financial Writer
Once approved, the home equity loan arrives in the form of a check or direct deposit. Usually, there is a fixed interest rate and fixed term of approximately 10 to 15 years. Monthly payments are made until the amount is fully paid off. Depending on a number of factors, home equity loans are usually lower APRs than credit cards.
What is a HELOC?
A home equity line of credit, also known as a HELOC, means that you are approved for the full amount, but the bank or lender will not provide a lump sum. Instead, the bank will provide a credit or debt card and/or a checkbook, where money can be withdrawn as needed. With this method, interest is only paid on money spent.
HELOCs are a little more complicated than typical home loans. For example, there can be fluctuating interest rates. As such, this means the payment could increase, anywhere from a small amount to an extreme amount. Most lenders offer low “introductory home equity loan rates,” so be mindful of a potential, future increase.
Next, there are Balloon Payment Terms to consider. Some HELOCs will charge interest for a certain period of time before making an adjustment to include a fee at the end of the term. This unpleasant balloon animal can sometimes even mean a secondary financial period to help pay for it.
Another route to consider would be an Advance Period Term. Essentially, this means a borrower can access money for a certain period of time—usually a few years. After that term expires, money can no longer be withdrawn and payback must be paid in full during what’s called a repayment period.
What is a Home Equity Loan?
“Commodities tend to zig, when the equity markets zag.”
—Jim Rogers, Investor
Depending on your necessary expense, there are several factors that determine whether or not you should consider such a loan. In addition, whether you choose to use a regular home equity loan or HELOC depends on specifics as well.
If your expense is a one-time renovation, such as a bathroom add-on or home repair, a regular home-equity loan may be the best option. Essentially, you’ll get the money you need for the repair and then you can jump on paying back the loan while enjoying your new addition or repair (payments also remain the same).
For those who need a series of payments over time and would like a safety net, then a HELOC would be ideal. In this example, consider something where there could be a series of unexpected payments. In addition, you can use money as you need it and only pay for what you use.
With either choice, they usually use a formula such as 75-80 percent of the home’s current appraised value, minus the mortgage, to provide the potential amount of the loan. The Wall Street Journal gives the following example:
Here’s an example that assumes the bank will lend 75% of your home’s value:
Current home value: $400,000
75% of current value: $300,000
Size of your mortgage: $250,000
Amount lent to you: $50,000
In most cases, lenders will give 80 percent or more of the current value. If your credit score is perfect, they could even give more than 100 percent of the appraised value, but there is always risk in a choice like this one. Consider that it’s always possible for you home’s value to decrease over time, simply due to the economy and not any fault of your own. Meaning, you could owe money after selling your home.
For a more specific example, consider using a Home Equity Loan Caclculator such as this one from BankRate.
Confirmation of Equity
Not to overstate the obvious, but you’ll need equity for such a loan. Equity, by definition, is the portion of the home that you currently own, meaning the mortgage owed to the bank is irrelevant as far as being beneficial.
If your home is valued at $300,000, but you owe $200,000, then your equity is $100,000, or 33 percent. This refers to a loan-to-value ratio, which is the balance of the loan compared to the property’s value.
More often than not, lenders require that you have 80 percent of the loan-to-value ratio remaining after the new home equity loan or HELOC. Ideally, this means that you should own more than 20 percent of your home, which most people do since most mortgages require a 20 percent down payment.
It’s a Second Mortgage (and the Risks Involved)
“If you are in banking and lending, surprise outcomes are likely to be negative for you.”
—Nassim Nicholas Taleb, Scholar
Don’t forget that a home equity loan is a second mortgage. Much like a primary loan, the stakes are high and risk is involved. The benefit of this scenario, much like a true mortgage, is tax-deductible interest for those who properly itemize deductions. Federal law allows up to $100,000 to be deducted from home equity debt.
Secured by your home, this second mortgage will have lower rates than a credit card or other example of an unsecured, discretionary loan, but higher than a mortgage. Failure to pay, again, means that foreclosure is possible. In this harsh scenario, delinquency means that the primary lender is paid first, then the equity lender.
Stay in Control (Don’t Overspend)
When someone puts their home on the line, overspending is a huge possibility. For those who get a home equity loan due to credit issues, the risk of getting in even deeper put those individuals at risk for “predatory lending.” This means that lenders are shaping high-interest loans around you purposely, and then adding fees.
There are, of course, laws and books out there to protect individuals from these sharks, but legislation and regulations aren’t always enough to protect those looking to get a secondary home loan. Fannie Mae and Freddie Mac are doing their part to protect borrowers but as home equity may be a last option, the threat remains.
Other Predatory Lending Examples
Finance companies who prey on the weak or ill fortuned have come up with a series of ways to harm the little guy, such as:
- 125 Percent Borrowed — New to the lender field, these amounts are meant to be beneficial, but could obviously be harmful. For those who make payments accordingly, it’s still possible that your home may not be worth its current appraisal value, and with a job loss, this is the most risky option.
- Equity Stripping — If a lender encourages a borrower to inflate income on an application, then they make be preying on the fact that the borrower will one day not be able to make their payments. Those guidelines, while often low in nature, are set for a reason. Don’t let foreclosure occur this way.
- Loan Flip — If a lender is requiring a borrower to “flip” an existing mortgage into a bigger term for an unnecessary benefit (like an add-on that isn’t needed or isn’t affordable), they may be planning to cash in on the interest.
- Negative Loan Partnerships — If a lender has partnered with someone who wishes to bring you harm, the homeowner is at risk. Consider something such as a contractor who recommends a lender, where they also see a future benefit in the deal. If trust has not been made, consider this a risk.
- Phrases that Deceive — Finally, make sure to read the fine print and avoid catchall words and phrases. “Low monthly payments,” “Low introductory payments,” and other examples could mean anything. Read the fine print.
Finding the Best Deal for You
“Be incredibly, ruthlessly selfish with your equity.”
—Douglas Leone, Capitalist
If these numbers have deterred you, then it’s time to start looking for a good deal. First, it’s important to consider that with home equity loans, your credit isn’t really as much of a factor. The approval and even the APR rates are only based on the fact that you have a home you are willing to put up for collateral. But, with that in mind, remember that your home is at risk if these payments aren’t made.
Unlike a mortgage, the approval process is rather smooth. It’s required to verify both your income and home’s value for an equity loan. Because this process is rather easy to provide, an approval could come in a matter of weeks if not sooner. With this quick turnaround, there could be fees involved. With fees and interest rates up in the air, shop around to find the best rates, despite your credit.
If you choose the HELOC, make sure you read the fine print to avoid those items discussed, such as a balloon repayments or other such fees. Some lenders make you withdraw money at various times over the agreed period and a heavy penalty could result if you choose not to (even thought you are trying to save money). Generally speaking, according to the Journal, credit unions offer the best home equity rates.
These Loans Aren’t for Small Thinkers
With a home equity loan, a lot of money is usually involved. In fact, lenders will not even bother with anything under $10,000 in most cases. According to Credit.com, Bank of America has a $25,000 minimum on their home equity loans, while Wells Fargo sits at a minimum of around $20,000 and Discover offers up to $100,000.
For those considering smaller amounts, the HELOC may be best once again. However, there are annual fees to consider and other fine print to read. For those spending small amounts, such as $5,000 of a $25,000 loan, the equity must still be vast enough to cover the full amount.
Home Equity Loans in a Nutshell
“When I hear of an ‘equity’ in a case like this, I am reminded of a blind man in a dark room – looking for a black hat – which isn’t there…”
—Charles Bowen, Judge
Compare and contrast your options with any loan to make sure you are finding the best deal for your situation. These days, this doesn’t even involve driving around or making cold calls. Instead, set up a series of online offers and let the deals come to you so they compete for you. After all, it’s your house, so you’re in control.
If a HELOC seems like the best idea, take some time to shape the formula in your favor. Determine your loan-to-value ratio, with the mindset that the more debt you have, the higher the rate will be. On occasion, there are even fixed-rate HELOC offers to those with decent credit and it never hurts to ask for a discount.
As a bonus tip, consider looking for a small bank. With the little guys on your side, there is more wiggle room to play with a loan. The big banks use a cookie-cutter formula, so visit the smaller banks and negotiate your rate. Good Advice Press reports, national banks were charging 9.30 percent while smaller banks may charge closer to 7.25 percent rates.
In addition to the smaller bank option, make sure to cut closing costs. Shop around and see what can be negotiated and what can be waived all together. When you’re ready to negotiate, keep going and ask for special deals, especially with small banks. Some may cut interest rates for you.
Finally, create a concrete re-payment plan and stick with it. Even the best rate and an amazing tax break doesn’t matter if you miss a payment. Since the amount will always add-up over time, try to pay more so you finish payment in five years, rather than ten for example.
|Home Equity Check List (from Consumer Finance)|
|Features||Option 1||Option 2|
|Fixed Percentage Rate|
|Variable Percentage Rate|
|Index / Current Value|
|Discount? How Long?|
|Interest Rate Cap|
|Term of Plan|
Just like when you purchased a new home, the terms of a home equity loan or home equity line of credit can sound enticing, first give serious though as to whether you truly need the funds before rushing out to apply. If you’ve ratcheted up high-interest debt, and see the equity in your home as a quick fix so you can start spending again, your overall financial health can take a destructive blow.
If you have the discipline to use the equity for something of vital importance and you can repay on time, you may consider yourself a good candidate. Always remember we live in an ever changing world with a less than stable economy.