Thursday, May 10, 2018

How Does A Home Equity Loan Work?

How Does A Home Equity Loan Work?
How does a home equity loan work? Pretty well, if you do it right. A home equity loan could be the most affordable way you can borrow for a special project or purchase.

As you pay down your mortgage, you build up equity (the difference between your mortgage balance and the home’s market value). Equity may also grow when home values rise drastically.

If you qualify, it’s possible to borrow against that equity as a second mortgage. You receive the money in a lump sum and pay it back over a fixed period (usually five to 15 years).

Because the interest rate for a home equity loan is lower than for personal loans or credit cards, it’s a popular way to borrow. According to the Federal Reserve Bank of St. Louis, homeowners financed more than $373.2 billion in home equity loans in March 2018.

How a home equity loan works

Home equity loans are generally figured at up to 85 percent of the home’s value, minus the balance of the current mortgage. Here’s how that would work for a $200,000 home, on which you owe $150,000:

- 85 percent of the $200,000 home value is $170,000

- Balance of current mortgage is $150,000

- $170,000 minus $150,000 equals $20,000

- Thus, you may be allowed to borrow up to $20,000

Qualifying for a home equity loan is similar to qualifying for a mortgage, and in fact, carries the same kinds of closing fees (more on that below). You’ll have to provide employment information, proof of income and bank statements; the lender will weigh this information along with your credit history, monthly expenses, debt-to-income ratio and, of course, the amount of equity in your home.

To get some idea of your potential borrowing capacity, use a home equity loan calculator like this one.

Once you apply and get approved for a home equity loan, you receive the amount you borrowed in a lump sum. Home equity loans carry fixed rates, and you make equal monthly payments over the term of the loan — just like you do with your first mortgage.

Ways to use home equity loans

Home improvement

People commonly use home equity loans for home renovations or upgrades, but you can use the money for anything you want. However, until recently the interest on a home equity loan was tax deductible, but the Tax Cuts and Jobs Act of 2017 changed that. From now until 2026, the interest on a home equity loan may be deducted only if it is used to “buy, build or substantially improve the taxpayer’s home that secures the loan” and meets other additional requirements.

But this may not be an issue for many homeowners. The standard deduction has also changed — so unless your deductions are higher than the standard ($24,000 for those filing jointly, $18,000 for heads of household and $12,000 for individuals), you probably won’t be itemizing anyway.

Debt consolidation

Home equity loan rates are relatively low because a HEL is a secured loan, and your home is the collateral — fail to make payments and you could lose the property through foreclosure. However, if you have a viable repayment plan, a home equity loan will reduce the amount of interest you’ll pay, versus the interest you’d potentially pay on a personal loan or credit card. Using a home equity loan to consolidate your debts also simplifies things, because you end up with one, fixed, monthly payment.

You might qualify even if your credit is less than stellar because your existing equity serves as loan collateral. Of course, the better your credit, the better the interest rate you’ll likely qualify for.

Medical debt is another common reason to borrow. After a serious illness or accident, a low-interest home equity loan is an affordable way to deal with expenses, such as hospital co-pays and any items or services that aren’t covered by insurance.

Business funding

A low-interest home equity loan can cover some start-up costs if you hope to become an entrepreneur or to expand an existing small business. Unless you have some other form of collateral, your home equity might be the only way to get affordable financing.

Of course, you need to weigh the risk of losing your home should your business and/or personal finances go south.

Education

Some parents take out home equity loans to help their kids get through college; you may consider this an acceptable risk. But think twice if your repayment plan includes (or relies on) the student beginning to chip in four years down the road — post-graduation jobs aren’t guaranteed, and neither is finishing school on schedule.

The costs of home equity loans

As with any mortgage, it’s necessary to factor in closing costs. Generally these amount to between 2 and 5 percent of the loan. Among the charges you’re likely to see are an application fee, home appraisal, document preparation, attorney or title company fees and title search. You may also be asked to pay for things like notary costs, credit report fee, flood elevation certificate and proof of property taxes.

Suppose the bank approves you for an 80 percent equity loan on your $200,000 home with a $100,000 mortgage balance, which comes out to $60,000. You decide on a 10-year loan term at 4 percent interest. Here’s how that looks:

- Closing costs: $1,200 to $3,000 up front

- Monthly payment: $607.47

- Total interest paid: $12,896.50

- Total payment: $72,896.50 (plus closing costs)

You can opt to pay points in order to lower the interest rate on your home equity loan. One point equals 1 percent of the amount of the loan, e.g., 1 point on a $300,000 loan means $3,000 upon closing. Talk to your lender about this.

It’s possible to retire the loan earlier than scheduled by making extra payments, provided there’s no prepayment penalty. Avoid loans that include such a fee, or ask that it be removed from the loan terms. Finishing the loan early means paying less interest.

When researching the best home equity loan, consider not just the best interest rate but also the lowest closing costs. For example, about half of Navy Federal Credit Union home equity loans are written without appraisals, according to Johnna Camarillo, assistant vice president of equity processing and closing. In addition, you can ask lenders to meet the conditions offered to you by a competitor — lowering the interest rate, say, or covering some of the closing costs.

“[Consumers] need to ask their lender what fees can they expect,” Camarillo says. “This is their money and this is their future, so they should be careful that they’re getting the best deal possible.”

When is a home equity loan a good idea?

A home equity loan makes sense when you’re committed to getting out of debt or looking for an affordable way to finance something you need.

But if you’re using a home equity loan to get out from under deep consumer debt, it’s important to address the root cause of those credit card bills. Paying off high-interest credit cards with a low-interest home equity loan can make sense, according to certified financial planner Delia Fernandez. But if you fail to address underlying issues, like compulsive shopping or failing to budget, the debt will likely return.

“A lot of people will use [a home equity loan] as a one-time, get-out-of-credit-jail thing. But you don’t want to do it twice,” says Fernandez, who works with middle-class clients in Los Alamitos, Calif.

How does a home equity loan work in terms of luxuries? The same way it does with credit card overspending: poorly. Risking your equity — and your home — for fleeting pleasures such as a cruise or a luxury vehicle doesn’t make financial sense.

What to watch out for

When comparing offers, make sure you understand all the language in the loan documents. Some predatory lenders play fast and loose with the rules; according to the Federal Trade Commission, you might see tricks like:

- Bundling insurance products you don’t need along with the loan

- “Loan flipping,” or encouraging you to refinance over and over

- Changing the initially agreed-on loan terms and pressuring you to sign anyway

- Encouraging you to take a larger loan than you can afford to repay

Read the final agreement carefully. If the home equity loan isn’t what you were told it would be, or if you get cold feet, ask for changes or walk away. Note: In most cases, federal law allows you three business days to cancel a loan agreement. For more information, visit the Federal Trade Commission website.

The bottom line

A home equity loan can be an affordable way to fund a personal or business project. If your budget can handle the monthly payments, a home equity loan could help you achieve your goals without paying high interest rates. Weigh the risks and make the best decision for your circumstances.