A home equity loan is a loan that is backed by the equity in your home and pays out a lump-sum amount up front to the borrower, who must repay the loan according to a preset schedule, such as over a 20 year period. Read on to find out how these loans work and whether they are right for you.
History of Home Equity Loans
Traditional 30-year mortgages first appeared after World War II, but it was another 30 years or so before home equity loans and lines of credit became common. For a long time, having any type of second mortgage on a home was a sign of financial desperation. But in the 1980s, the banking industry successfully erased that image with aggressive marketing campaigns that touted the advantages of home equity loans and lines of credit. One of the most common slogans was, “That ‘unused’ home equity in your house? Put it to work for you.” Of course, this was just a euphemism for borrowing. But the public bought into this illusion full force.
This easy-to-obtain form of credit quickly ballooned from $1 billion outstanding in the 1980s to over $1 trillion before the Subprime Mortgage Meltdown of 2008. However, the number of homeowners who are at least a month behind in their home equity loan or HELOC payments rose over 50% above the average that has been tracked by the American Banker Association since about 1990. The number of delinquent borrowers rose by 45% even before the Subprime Mortgage Meltdown.
Before the 2008 meltdown, many lenders were willing to provide borrowers with loans equaling 100% of the equity in their homes, minus the balance of their first mortgages. But when the meltdown hit, it reduced the market value of thousands of homes to a level below the amount of debt that was carried on them. Thousands of borrowers were then left upside down on their home loans. These unfortunates owed more money on their homes than they were worth.
Home equity loans have made a comeback in recent years as housing prices have steadily increased and the economy has recovered. Just about any homeowner who has steady income, a decent credit score and some measure of equity in their home is eligible to take out one of these rate loans.
How Home Equity Loans Work
Home equity loans are, quite simply, second mortgages that you can take out on your house. They provide a fixed amount of money that must be repaid over a fixed amount of time and charge a fixed rate of interest. The terms of the loan will be determined by your income, monthly cash flow, credit score and the value of your home.
Most home equity lenders will cap the amount that they loan out at 80 or 85% of your home’s current value, minus the amount of your first mortgage. This limitation came in the wake of the aforementioned Subprime Mortgage Meltdown of 2008.
You will immediately begin paying the interest on the entire loan balance and will continue to do so as long as there is an outstanding balance on the loan. Home equity loans can have repayment periods ranging anywhere from 10 to 30 year terms. It is not necessary to have an outstanding balance on the first mortgage in order to obtain a home equity loan.
Home equity loans also come with the same litany of fees as first mortgages, including application fees of $100 or more, origination fees of 1-2 points of the loan balance, appraisal fees that can range anywhere from $150 to $300, attorneys’ fees, document preparation fees and recording fees. So don’t be afraid to shop around with various lenders and types of lenders in order to get the best deal. You can talk to banks, credit unions, private lenders, mortgage brokers and originators to get a feel for what the best deal and the best rates will be for you.
Borrowers can set up an automatic payment to pay their HEL bill each month, and they can also take out a home equity loan in lieu of a cash-out refinance.
How to Qualify
Qualification – In order to get a home equity loan, you will have to go through the same underwriting process that you would as for any other type of loan. The lender will pull your credit report to evaluate your credit score and credit history, the loan-to-value ratio of the loan, your primary mortgage balance, your income and expenses, home value and the total amount of debt that you’re carrying. These factors will determine the terms of your loan, such as the interest rate and time until repayment is made in full. As mentioned previously, you will have to pay the same underwriting fees that you did for your first mortgage, such as application fees, origination fees, appraisal and document fees and attorneys’ fees.
Ready to learn more?
There are more home equity topics to be discovered on our blog.
The Difference Between HELOCs and Home Equity Loans
Although they are often used for similar purposes, there are several key differences between a home equity line of credit and a home equity loan. While home equity loans charge a fixed rate of interest, home equity lines of credit usually charge a variable rate of interest that is tied to a major financial index such as the U.S. Prime Rate Index, which is published daily in The Wall Street Journal. HELOCs also usually charge lower interest rates than home equity loans.
The loan terms for HELOCs and home equity loans are also fundamentally different. HELOCs function in much the same manner as a checking account, as borrowers can draw on them at any time up to the prescribed limit. Borrowers only pay interest on the amount of their lines of credit that are currently outstanding, while borrowers of home equity loans will immediately start paying interest on the entire loan amount.
For example, if one borrower gets a HELOC for $100,000 and draws out $20,000, then he or she will only pay interest on the latter amount. A borrower who borrows $100,000 using a home equity loan will pay interest on $100,000 immediately. Some HELOCs also offer interest-only payments based on a variable interest rate while home equity loans do not. Home equity loans also do not have “draw periods” like HELOCs do, but they charge interest over the whole life of the loan, whereas HELOCs will not charge interest if nothing is withdrawn.
How Home Equity Loans are Calculated
As mentioned previously, home equity loans are calculated based upon your home’s value, your credit score, the amount of other debt that you are carrying as well as your monthly income and expenses. There are many calculators online, such as the one at bankrate.com that will compute your monthly payment after you plug in your loan balance, interest rate and the term of the loan.
Best Times to Use a Home Equity Loan
There are several instances where it makes sense to take out a home equity loan. Perhaps the most obvious reason is debt consolidation. If you have substantial balances on several credit cards, auto loans or personal loans that are charging you at least 20% interest, then you would be wise to consolidate that debt into a home equity loan that may only charge a third as much. Of course, your home’s equity needs to be large enough to cover these bills.
Other good reasons to take out a home equity loan are to pay for major expenses such as medical or educational bills or some other expense that is clearly defined. If you need to come up with $40,000 immediately to pay for an expense, then a HEL is the logical choice for funding, as you can take out a loan for exactly the amount you need with the terms of the loan being clearly defined.
Home equity loans can also be used to purchase vacation properties, rental properties or other real estate, to start a business or for home improvements. There is no real limit to what you can use these loans for. Just make sure that you’ll be able to make the additional payment once you’re approved.
Disadvantages of Home Equity Loans
Probably the biggest disadvantage that comes with a home equity loan is the fact that you can lose your home if you become unable to make the monthly payments on the loan. This is true even if you are making the payments on your primary mortgage on time with no problem. Another possible disadvantage is the fixed interest rate. While this can be an attractive feature when interest rates are rising, the opposite is true if rates are falling. It's not much fun if your annual percentage rate on one of these loans is 5% when prevailing interest rates are two percent lower. It can also be tempting to take out a home equity loan and spend it on luxuries and frivolities, instead of improving your home or investing the money at a higher rate than you're paying on the loan. Finally, the closing costs for a home equity loan can be every bit as high as they were for your first mortgage.
Ready to learn more?
There are more home equity topics to be discovered on our blog.
Important Laws & Rules with Home Equity Loans
Under the old tax laws, the first $100,000 of home equity loan debt was tax deductible as an itemized deduction along with the interest you paid on your primary mortgage. Unfortunately, Trump’s new tax laws have removed this deduction, so only the interest on your primary mortgage is still deductible. The only exception to this removal is when the HEL is used to add on to or improve your primary residence. The homeowner’s primary or secondary home must be used as collateral for the loan, and the loan balance cannot exceed the total value of the home.
Federal law allows you to cancel any signed agreement for debt financing within three business days of signing the agreement. This is referred to as the “Three-Day Cancellation Rule. You can cancel for any reason as long as the debt is backed by your primary residence. This does not apply to vacation or rental homes. Saturdays are counted as business days, but not Sundays or public holidays. This rule gives you until midnight of the third business day to cancel after you have:
Signed the credit contract
Received the Truth in Lending Disclosure From outlining the terms of the loan contract
Received two copies of the Truth in Lending Act explaining your right to cancel
If you decide to cancel, you must notify the lender in writing. A verbal cancellation is not valid, either by phone or face to face. A written notice of cancellation must therefore either be delivered in person, mailed or electronically filed before the deadline in order to be valid.
Exceptions to the Three-Day Cancellation Rule include:
When you will use the loan to add on to or modify your current residence
When you refinance existing debt with the same lender and don't borrow more money
When you are borrowing from a state agency
In these cases, you will most likely have other rights of cancellation under state or local laws.