Have you ever heard a mortgage referred to as a forced savings account? When you build up your home equity, you can convert that into cash to pay for major expenses – like home renovations, debt repayment, or retirement. There are a few different tools for homeowners looking to harness their equity: one of the most common is a home equity loan.
What Is a Home Equity Loan?
Home equity is the difference between the current value of your home and the amount you still owe on your mortgage. For instance, if your home has an appraised value of $300,000 and the remaining balance on your mortgage is $180,000, you have $120,000 in home equity. If you have a substantial amount of home equity, you can use it to get a home equity loan.
A home equity loan lets you pull cash out of your home equity with your home as collateral. The amount you’re allowed to borrow depends on how much equity you have, which is related to how much your home is currently worth, and it usually comes with a fixed interest rate. You’ll receive a lump sum upfront after your loan is approved. Then, you make monthly payments until the loan is entirely paid off.
What Are the Advantages and Disadvantages of a Home Equity Loan?
Before we discuss what home equity loans should be used for, let’s take a look at the advantages and disadvantages of this type of loan. This can help you better understand what you’re getting into and determine whether it’s a suitable option for you. The following are the pros and cons of getting a home equity loan:
- Low interest rate: A home equity loan almost always has a competitive interest rate because it’s a secured loan. Since you use your home as collateral, the risk is reduced for the lender, which translates to a lower rate.
- Low monthly payments: Compared to other types of loans, a home equity loan generally has a longer repayment term, which usually ranges from 10 to 30 years. With such a long loan term and a low interest rate, you can expect to affordable monthly payments.
- Tax deductibility: If you use your home equity loan to buy, build, or upgrade your home and your mortgage debt doesn’t exceed government limits, the interest you pay on the loan can be tax-deductible.
- Risk of foreclosure: Since you’re using your home to secure your home equity loan, you’re at risk of losing your house. Foreclosure is a possible outcome if you’re unable to make your monthly payments. As such, you have to carefully select a loan amount and term that enables you to comfortably repay your loan even in adverse economic conditions.
- Large loan amount: A home equity loan isn’t a flexible financing option in that it doesn’t allow you to borrow a small amount of money. Instead, you’re required to borrow a lump sum and pay interest on the full amount. The minimum loan amount is usually $30,000, but it can be as low as $10,000 from certain lenders.
- Strict eligibility requirements: Different lenders may have different eligibility requirements for home equity loans. However, you typically need to have a steady income, a minimum credit score of 680, and a debt-to-income ratio of 43% or below to qualify for a home equity loan. Your debt-to-income ratio is the portion of your gross monthly income that you use to make your monthly debt payments.
What Can a Home Equity Loan Be Used For?
In most cases, there are no restrictions for how you use the funds from a home equity loan. You have the freedom to use your home equity loan as you wish. However, most people choose to spend their loan money on the following:
- Home improvements: Besides creating a more comfortable living environment for you and your family, home improvements can also increase the value of your home and help attract more prospective buyers when you decide to sell it in the future. They’re a great way to use a home equity loan because they can sometimes pay for themselves by raising your home’s value. Additionally, they may make you eligible for tax deductions. Examples of home upgrades that yield a good return on investment include adding square footage or outdoor structures. However, popular renovations like bathroom and kitchen renovations, window replacements, attic insulation, roof replacement, and smart home technologies can improve curb appeal and help protect the value of your home.
- Emergency expenses: If you’ve lost your job or accumulated large medical bills, it may be a good idea to take out a home equity loan to keep yourself afloat. However, you should only consider doing this if you have an effective plan to repay the loan or your financial problem is only temporary. Also, bear in mind that applying for a home equity loan can be a lengthy process, so it may not be the ideal option for dealing with a time-sensitive emergency.
- College costs: When mortgage interest rates are significantly lower than student loan rates, it makes financial sense to use a home equity loan to fund a college education. You’ll also have a longer time to pay back the loan, which reduces your monthly payments. Try to look for a good deal on a student loan first before you decide to tap into your home equity. If you do ever default on a student loan, you’ll only hurt your credit score and not lose your home.
- Debt consolidation: A home equity loan is widely used as a debt management strategy – provided you can qualify. It enables you to consolidate your debts to get a lower interest rate, extend the repayment term, and reduce your monthly payments. Nevertheless, you’ll be turning your unsecured debts into secured debt and putting your home at risk.
Now that you know what home equity loans can be used for, you may want to start looking for the right home equity financing solution. If a home equity loan isn’t the right choice for you – for example, if you can’t take on an additional monthly payment or have trouble qualifying – consider using Point’s Home Equity Investment (HEI). With an HEI, you get up to $350,000 with no monthly payments. In exchange, Point will share a portion of your future home appreciation. Point is never added to the title – you maintain full control of your home. Contact us today to learn more.Tags: Home Equity