The home equity loan is one of the many options in the world of home financing and refinancing.
The home equity loan is also known as a second mortgage or a term equity loan.
- It is similar to traditional loans in that they are paid monthly over a set period of time.
- A home equity loan differs from fixed or adjustable-rate plans in that your home serves as collateral, so you have access to some or all of the accrued equity in the form of cash.
- The amount you borrow is tax deductible, an extremely attractive aspect to many homeowners who want to fix up, remodel or just need a lump sum for a large expense, such as a child's education or an unexpected medical bill.
- This type of loan is more easily approved than a first mortgage because you are borrowing against your equity (your money), so it is a lower risk to the lender.
- You get the loan faster, which is why taking a home equity loan is one of the most risky refinancing options: your house is on the line. If you default on payments, you stand to lose your home.
- You are also deducting any equity you have built up thus far.
When applying for a home equity loan, approach it much the same way you did your original home loan/mortgage.
- Check with your existing mortgage lender to get a quote on any points and fees
- Then work with your mortgage professional to find the best deal for you.
Most lenders work out a number around 75 to 80 percent of your home's value, but increasingly more lenders let you borrow as much as 125 percent. While 125% is a tempting amount of cash, it can be dangerous territory if you push yourself into debt farther than you are able to crawl out.
In order to qualify for a home equity loan, you must have:
- adequate equity (as determined by a lender-approved appraiser)
- a good credit record
- proof of income sufficient to pay both loans
- a total indebtedness that meets qualifying ratios
When (or before) you qualify, it's smart to make a plan with specifics on how you will repay the loan.
- Concentrate on keeping your credit clean, as lenders monitor your credit and if it worsens, could reduce or freeze your credit.
- Never, ever use your equity loan money for day-to-day expenses. It just doesn't make good financial sense.
There are three basic types of home equity loans:
- second mortgages
- home equity loans
- home equity lines of credit
Second mortgages replace the first mortgage, almost always at a lower interest rate. When you refinance with a second mortgage and take out some of your equity, you can use it in the form of cash at your discretion.
If you choose a fixed-rate loan, your payments won't go up for the life of the loan. If you take on a new 30-year loan, you substantially increase the time you will pay interest and principal on your home. The good news is, you may be able to get out of your Private Mortgage Insurance (PMI) if you took it on as a requirement of your first mortgage. This is contingent on the new loan being 80 percent or less of your home's value.
If you cut your mortgage to 15 or 20 years, you will pay off your loan sooner but your monthly payments will most likely be higher. If the amount is one you can afford, the shorter mortgage can save thousands in interest.
Home equity loans - you don't take out a new loan, but simply borrow money from your equity. The amount you pay back is usually in fixed amounts over a specific period of time - around 10 to 20 years.
As previously stated, some of these loans will actually allow you to borrow more than the amount of your home, which puts more cash in your hand. However, these loans often come with higher fees and more points and borrowing more than the amount of your home may put monthly payments higher than you can reasonably pay. It's dangerous to gamble with your house on the table, and in this case you can't get tax write-offs either. Finally, watch out for the balloon payments and prepayment penalties.
Home equity lines of credit are very much like a credit card and you actually get a card to put in your wallet and use at will. Typically there is a fast approval period, very few up-front costs, and no interest charges until you use the cash. This is convenient when you need to pay for ongoing home-improvement projects or some other recurring payment item.
It poses the same dangers as traditional credit cards, making it a less-than-wise choice for those easily tempted by the convenience of credit cards. Most equity lines of credit are adjustable rate loans, so your interest charges change accordingly and every withdrawal has a fee attached.
- Beware the balloon payment: Low interest rates are sometimes only made possible by requiring that you pay the remainder of the balance in one lump-sum payment at the end of the loan term, the balloon payment. This is difficult for most people to pull off. Read the terms of your loan, and know where the funds will come from.
- Negative amortization: means that your monthly payments don't cover all the interest you owe. The interest accrues and increases the total amount, so that you end up paying far more than the amount you originally took out.
- Extra documents: At closing, you could be asked to sign extra documents you haven't seen before. You don't have to sign these, and you should ask why your lender wants you to sign it. If you refuse to sign the extras and your lender says your loan papers will have to be reconsidered or rewritten, walk away and find a different lender.
- Prepayment penalties: Many lenders do not view paying off your debt early as a good thing, and some actually charge a stiff penalty for doing so. Examine the terms of your loan closely to see if you will be penalized for paying early. If so, get out of the deal: there is no reason you shouldn't be allowed to get out of a high-interest loan early.
- "Home improvement" loans: Sometimes a lender works with a contractor and, at the outset, offers a great deal (low-cost financing), but you don't receive the loan documents to sign until the work has already begun. They apply inflated rates and if you object, the contractor may threaten to leave the work undone. Be extremely thorough in your understanding of your loan and its terms, and always sign before work begins.
- Grace period: Though not literally a pitfall, it could become one if you aren't aware of it. All borrowers have the legal right to rescind (or walk away from) their loan within three days of signing. Inform your lender in writing that you wish to do so within these three days. At this time the lender must cancel the security interest in your home and return all fees, including the initial application and appraisal fees.
When refinancing using your home's equity, your home must be appraised to determine its value and therefore its equity. The appraiser must be one preapproved by your lender. If not, your loan paperwork cannot proceed until the appraiser fills out a mountain of paperwork to establish himself as a reputable appraiser in the lender's eyes.
The appraiser approval process is of utmost importance, because both the lender and investor must determine that the appraiser's work is proven at the required quality level. This includes a working knowledge of the area's property values because the amount established by the appraiser determines how much a lender (and investor) must pay. This makes the proper insurance amount extremely important to both parties.
To be approved, an appraiser must submit a multi-page biography and samples of work - typically one example of every type of home - in the same geographic area. The samples must be in the current time frame, as older samples might contain rates that are no longer comparable.
Once satisfied with the appraiser's qualifications and experience, the lender issues approval and your loan process continues.
With recent mortgage rate drops, many people are unsure whether to lock in a great rate or float the rate hoping for an even better rate. Regardless of market changes, when you lock in a rate, you are assured of that interest rate and loan pricing. This is comforting when market levels spike. When they fall, locked-in customers may not be so happy.
Most lenders offer the option of locking in a rate over either 15, 30, or 60 days - but no fewer than 5 days before closing. If rates drop by 3/8- to 1/2-point, lenders will probably renegotiate your lock, so it pays to be on top of market rates during your loan process.
There is a fee for locking in a rate because it costs the lender to reserve the funds at the current rate for later delivery. Sometimes, a longer lock results in a higher fee, which is figured into a higher rate or the addition of points or fractions of points.
Floating a rate allows you to take advantage of falling rates before you close your loan. You may switch from floating to locking in a rate at any time, usually when the market hits a number you like. Without the protection of the lock, if the market rate rises you risk paying the higher amount. There’s an inherent gamble when you float your rate, but when market conditions are favorable, it can make sense.
Despite the hassles of applying, being approved, and securing a sensible repayment method, access to some or all of your home equity in cash is a nice thing.
Use this money is to increase your home’s value through repairs and upgrades, putting money back in your house and your pocket. The most effective value-increasing improvements are updated bathrooms and kitchens. Additions are fruitful if they are a natural extension of the original house in both structure and design.
Put the money toward college tuition for you or your children. This is a sound investment as an educated child usually makes a better salary. This can translate into the ability to help you when you are old and gray and in need of their help. Investing in your own education can increase your knowledge, skills, and marketability, which usually translates into a higher salary.
Consolidating debt is another effective outlet for equity dollars. Pay off your debt then pay one smaller monthly bill with a lower interest rate (since your home secures that debt). Having a single credit bill increases your credit standing since you are viewed as a less risky borrower. Understand how you got into debt in the first place: cut up all but one credit card that is designated for emergencies only. Reevaluate your finances and apply new spending and savings habits that will lead to a more financially secure future.
When Your Home Is on the Line
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