A home equity loan is one where the borrower is required to use the equity in their home or property as collateral in order to get the loan. The amount you get would be based on the value of the property.
What Is A Home Equity Loan?
Home equity loans are considered to be a second mortgage that borrowers can take out by using their home’s equity as collateral. These loans are a convenient option for individuals looking to obtain funding for different activities, such as launching a business, remodeling the property, or financing an investment operation.
Most lenders offer home equity loans due to their low-risk nature, and, because of the collateral, interest rates are often lower than personal loans. Continue reading for an explanation on home equity loans, how they work, and their main benefits and disadvantages.
How Does a Home Equity Loan Work?
Most homeowners finance the purchase of their properties by using mortgages. Mortgages are issued by financial institutions, and their amount varies depending on the value of the property. In most cases, the transaction is funded through the loan as well as a down payment (commonly from the borrower’s own savings), and the home’s equity will typically be equal to the amount of the down payment.
Subsequently, as the borrower pays for each installment of the mortgage, the balance is reduced, and the portion of the property that is owned by the borrower increases. This portion is known as the equity portion. This portion of the property that the borrower owns can be used for a home equity loan, which is considered to be a second mortgage on the property.
The financial institution has a claim on the property’s value, so if the borrower defaults on their payments, the property can be foreclosed to cover for the loan’s outstanding balance.
The volume of home equity loans in the United States reached a peak during the 2008 subprime crisis, but since then, their volume has progressively declined. By the end of 2019, the value of home equity loans in the United States was approximately $318 billion, a 46% decline compared to their value in 2008, which was nearly $590 billion.
Benefits & Disadvantages of Home Equity Loans
Just like with other financing instruments, obtaining a home equity loan has various advantages and disadvantages:
Benefits of Home Equity Loans
- Applying and getting approved for a home equity loan is generally easier than a personal loan as the collateral involved reduces the risk of the loan from the lender’s perspective.
- The interest rates of home equity loans are typically lower than personal loans since the loan is secured by an underlying property.
- The repayment period for home equity loans is usually longer than other consumer loans, which reduces the cost of the installments.
- Home equity loans are a suitable alternative for individuals with challenging credit situations as the requirements to get approved for one are usually less demanding.
Disadvantages of Home Equity Loans
- If the borrower fails to pay the installments, the property may be foreclosed, and the borrower will lose the property as a result, especially if the market value of the property exceeds the outstanding balance of the combined mortgages.
- If the property is sold, the borrower will have to pay the entire balance of the home equity loan immediately. This might result in losses if the closing price of the home was lower than the outstanding balance of the mortgages.
- Borrowers must pay certain fees to obtain a home equity loan that are not charged for other types of consumer loans.
- Using a home equity loan to finance risky business ventures or unproductive activities may lead to severe capital losses.
Applying for a Home Equity Loan
The specific requirements to apply for a home equity loan varies between lenders, but most lenders impose some of the following conditions:
- The borrower should own at least 15% to 20% of the property to be considered a suitable candidate for a home equity loan.
- The combined loan-to-value ratio of the property should not exceed 80%.
- The borrower’s debt-to-income ratio should be lower than 43%.
- A minimum credit score of 620 is usually required.
- The property that will be used as collateral has to be appraised by a third party which is approved or appointed by the financial institution.
Repayment of Home Equity Loans
Home equity loans are issued as a lump sum payment, and they can be used for various purposes. These loans are repaid through a set of installments that usually extend from 10 to 25 years.
Each installment contains a portion of the loan’s outstanding balance and an interest charge paid to the lender as compensation for facilitating the funds. As each installment is paid, the homeowner progressively recoups a portion of the home’s equity.
Taxation of Interest Paid on Home Equity Loans
Prior to 2017, the interest charges paid on home equity loans were fully deductible from a person’s taxes. This increased the popularity of these loans since they were a cheap alternative to other types of consumer loans.
Nevertheless, the Tax Cuts and Job Acts of 2017 eliminated the possibility of deducting the interest paid on these loans except for situations where the loans are used to buy, build, or improve the taxpayer’s home.
This modification lowered the appeal of home equity loans, even though they are still an attractive option due to the lower interest rate charged on home equity loans compared to personal loans.
Foreclosures as a Result of Defaulted Home Equity Loans
Since a home equity loan works as a mortgage, the underlying property serves as collateral if the borrower fails to fulfill their financial obligations. This means that lenders have the right to foreclose on the home, even though they can decide not to under certain circumstances.
For example, if the value of the loan is significantly lower than the value of the property, the lender will probably choose to foreclose on the home. There’s a high chance that they will obtain enough money from selling the property to cover for the outstanding balance of the debt.
On the other hand, if the value of the home has declined and is now lower than the outstanding balance of the debt, the lender may decide not to foreclose the home as it will probably result in a financial loss. Nevertheless, the lender could still file a legal claim against the borrower, which could ultimately affect their credit situation.
Home Equity Loans & Credit Scores
A borrower’s payment history on a home equity loan can affect their credit score. These loans are treated as a regular credit account, and any late payments will negatively impact a person’s credit situation.
Home Equity Loans vs. Home Equity Lines of Credit (HELOCs)
Home equity lines of credit (HELOCs) are also considered a second mortgage, but they work differently than home equity loans as they are revolving credit accounts. This means that instead of a lump sum payment, HELOCs allow the borrower to withdraw money from the credit account and repay the balance at any given point during the draw period.
Some of the most important differences between a home equity line of credit (HELOC) and a home equity loan:
- Availability of the funds: A home equity loan usually provides the borrower with a lump sum payment for the entire amount of the loan, while a HELOC functions similarly to a credit card. The borrower can take money out of the credit line at any point during the draw period and repay it as they please. Once the draw period ends, no further withdrawals can be made, and the borrower must pay back the loan’s principal, along with the interest charges applicable during the repayment phase.
- Freezes: Since a home equity loan is extended through a lump sum payment, the lender cannot ask the borrower to pay the full amount of the loan during its lifetime. On the other hand, a lender could freeze a HELOC and immediately move it to the repayment phase if the value of the property falls below the outstanding balance of the combined mortgages. This will prevent the borrower from accessing the funds associated with the loan.
- Repayment of the principal: In a home equity loan, each installment contains a portion of the principal associated with the debt, which means that the loan’s outstanding balance diminishes progressively after each installment is paid. In contrast, the principal of a HELOC starts to be repaid once the draw period ends, and lenders may give the borrower the option to pay for it through a set of periodical installments, or, in some cases, a lump sum payment may be required.
- Interest rate: Fixed-rate home equity loans charge the same interest rate on the loan’s balance throughout its lifetime, while the interest of variable-rate home equity loans fluctuates based on the market’s conditions. HELOCs, on the other hand, are usually variable-rate loans, which means that the interest rate may vary from one installment to another.
Check out the rest of the CreditNinja Glossary to learn more about personal finance, like budget tips, mezzanine loans, home equity loans, and more.
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