What is Home Equity Loan?
A home equity loan is a form of ‘consumer debt’ that allows homeowners to avail loans against the equity in their residence. This equity is kept as the collateral to avail the loan. This type of loan can be accessed against both residential and non-residential property. It is also termed a second mortgage, a home-equity installment loan, or an equity loan. The amount for the loan is calculated based on the current market value of the property. To avail of this type of debt, one should have an outstanding credit history with considerable individual loan-to-value ratio and combined loan-to-value (CLTV) ratios.
The home equity loan is a way of incrementing the value of your home without the need to sell it. When you make repayments on your home loan and with time the value of your home appreciates, the ownership of your house equivalently grows. This ownership is actually your equity, which can be converted into debt (cash exchange) by availing the home equity loan.
Geeky Takeaways:
- Definition: A home equity loan is a type of consumer debt which is also known as a second mortgage, home-equity installment loan or an equity loan.
- Measurement: The value of the home equity loan is measured on the difference between the current market value of the house and the owner’s remaining mortgage payment.
- Types: There are two types of home equity loans: Fixed-rate loans and Home Equity lines of credit (HELOCs). Fixed-rate loans provides a fixed amount during the term of loan while HELOCs are flexible loans offering payments depending on the financial situation.
- Benefit: Home equity loans offers the owners of house to borrow against the equity they possess. It can be used when faced with a financial turmoil that threatens the livelihood.
How a Home Equity Loan Work?
1. Mortgage: The title of ‘second mortgage’ is defined as the home equity loan is related to a mortgage and the equity in the property acts as the collateral for the lender. The traditional home equity loans have a fixed term as that of the conventional mortgages. The borrower needs to repay the principal and interest during the fixed tenure and if the borrower defaults in repaying, the home could be sold to the lender to cover the outstanding debt.
2. Value: The amount that a borrower is allowed to avail is based partially on the combined loan-to-value (CLTV) ratio of 80% – 90% of the estimated property value. The amount of loan and interest rate is charged also based on the credit score and payment history of the borrower.
3. Conversion: Home equity loan is a way of converting the equity of the home into cash. It serves better when that cash is used in renovating the house and increasing the worth of the house. One should keep in mind that as their home is used for this loan, if the real estate price decreases, he/she could end up owing more than the value of the home.
4. Precaution to be Taken: If one is willing to relocate, he/she might end up losing money if the house is sold or is unable to move. Further, if the loan is availed to pay off debt of the credit cards, he/she should reconsider the urge of using up those credit cards again. One should always look into all the options available before assigning their house into jeopardy.
Advantages of Home Equity Loan
1. Easy Source of Cash: Home equity loans offer an easy source of cash and can be a beneficial instrument for responsible borrowers. With fixed source of income and capacity to repay the loan, low-interest rates and feasible tax deductions make the home equity loans appear to be a good measured choice.
2. Budget friendly and Easy to avail: Fixed rates help in determining the payment which makes budgeting easier. Further, as home equity loan is a secured loan, the lender only checks the creditworthiness of the borrower and the CLTV to disburse the loan to the borrower.
3. Lower Interest Rates: These loans offer a lower interest rates compared to other personal loans or credit cards. Hence, consumers avail this loan against their homes as collateral to pay off credit card dues. Further, if the loan availed for home renovation or improvement, the interest get deducted.
Disadvantages of Home Equity Loan
1. Easier to Fall into Debt: If the borrower falls into the trap of the perpetual cycle of spending, borrowing, spending and then drowning deeper into debt, then lenders reload the loan amount by paying off existing debt and disbursing only the remaining credit to the borrower.
2. Risk Associated: If the borrower fails to repay the loan amount, the home would be sold to the lender. Further, if the borrower wishes to sell their home before the repayment of the loan, the balance of the loan will be due.
3. Taking Loan more than the Worth of the House: The borrower might be tempted to avail loan more than the worth of their home which would lead to higher interest rates as the loan is not fully secured by the collateral and the excess loan amount is taxable. Further, the temptation by the borrower might arise knowing that another loan might not be availed in the near future.
Home Equity Loan Rates in 2024
Most of the home equity loans are listed based on the industry base rate or the prime rate. Although, lenders might add an extra amount to determine their final offer rate, the prime rate represents the lowest credit rate which the lenders offer to attract borrowers. Suppose, a lender puts an extra rate of 1.45% to the prime rate of, say 7.75%, than the home equity loan rate for the borrower would be 9.20%.
This marginal rate varies among the lenders, thus the borrowers need to look for the best rates before applying for the loan. Irrespective of the lenders, borrowers with greater credit scores and lower debt-to-income ratios or CLTV ratios are more likely to avail the best rates for the home equity loan.
- Current prime rate: 8.50% (as of November, 2023)
- Prime rate in the month of October, 2023: 8.50%
- Lowest Prime rate in the past year (2022): 7.50%
- Highest Prime rate in the past year (2022): 8.50%
Home Equity Loan Requirements
Different lenders have different requirement for offering home equity loans. Generally, the borrowers should fulfill the following conditions:
- Equity in their home should be at least 15% to 20% of the home’s value.
- Verifiable income history of more than two years.
- A credit score of more than 620.
- Debt-to-income ratio should be less than 43%.
If these requirements are not met, still the borrower can avail the home equity loan but with a higher interest rate from a lender who specializes in high-risk borrowers. Further, to determine the fair price of the house (collateral), the lender would estimate the borrowing capacity of the borrower.
How Much can you Borrow with a Home Equity Loan?
Generally, a home equity loan allows one to borrow around 80% to 85% of the CLTV (combined loan-to-value) ratio. This ratio is actually the difference between the market value of the house and the amount of borrowings. This CLTV ratio includes the total of the mortgage balances, existing HELOCs, existing home equity loans and the newly applied home equity loan and cannot be more than 90% of the estimated home value. Sometimes, lenders offers 100% of the CLTV ratio for borrowing.
For instance, the value of your house is $350,000, the amount of borrowing is $200,000 and the lender would offer 85% of your house’s value. Multiply the house’s value ($350,000) with 85% or 0.85. This gives a maximum amount of $297,500 that could be borrowed. Now, the amount of borrowing or the mortgage amount is subtracted to get a value of $97,500 ($297,500 – $200,000), which is the maximum approximated value that you can borrow as the home equity loan.
What can you use a Home Equity Loan for?
A home equity loan is best used for improvement, renovation or repair which will appreciate the value of the house. In US, as per 2021 American Housing Survey report, an average amount sourced from the home equity loan was $11,240 for series of housing projects. An amount of $35,000 was used for kitchen renovation by the houseowners as per the report.
Borrowers can avail home equity loan for anything they wish for, but it is highly suggested to use the equity amount to finance vacations or similar expenses which would not add up to wealth of the borrower.
Home Equity Loans vs. HELOCs
Usually, home equity loans are fixed rated while only some of HELOCs (Home Equity Lines of Credit). The basic difference between these two are tabulated below:
|
Interest Rates
|
Usually home equity loans are fixed rated
|
HELOCs offers variable rate of interest.
|
|
Credit
|
A lump sum amount is provided during the initial period of loan.
|
A line of credit is offered to the customers or borrowers.
|
|
Mode of Repayment
|
Repaid through fixed monthly installments
|
The repayment amount changes over time.
|
|
Term of Repayment
|
The repayment term begins immediately after the disbursement of the lump sum amount.
|
The repayment is limited to the interest during the term of the loan. The principal repayment starts at the time of repayment phase.
|
|
Who can avail
|
Suppose, during the start of a business, a lump sum amount is required, then this fixed rate home equity loan can be availed.
|
If phase wise cash is required during emergency situation (suppose), then HELOC may be availed.
|
|
Time Period
|
Generally 5 to 15 years
|
Drawing period (5 – 10 years) and repayment period (10 – 20 years)
|
|
Available in India
|
Highly available in India
|
Not available in India
|
FAQs
1. If you apply for a Home Equity loan, will you be tax benefited?
Answer:
No. This loan carries no tax benefits. Tax benefits are only available on the principal and interest amount of a home loan.
2. What purposes can one use a Home Equity loan for?
Answer:
A home equity loan can be used for any personal purposes from taking a vacation to paying medical bills to covering on educational expenses, and so on. It need not be used only on house expenses. But before using the loan for other expenses, look for other options as well.
3. What is the maximum loan amount you can get as Home Equity loan?
Answer:
The loan amount depends on the market value of the home and if there are other loan obligations to fulfill towards the property.
4.Can you get a Home Equity loan without using your home as collateral?
Answer:
No. For applying this loan, your house will be have to used as collateral as the loan amount depends on the market value of your house. However, you can avail a secured personal loan if you wish to use any other collateral.
5. How much does it cost to get a home equity loan?
Answer:
Similar to first mortgage, Home Equity loans comes with closing costs. These costs are rated between 2 – 5% of the total loan amount and includes factors such as origination fee, appraisal fee and credit report fee. However, there are some lenders who avoid charging closing cost.
6. Is having a good credit score necessary for availing a home equity loan?
Answer:
No. A good credit score doesn’t stop you from availing a Home Equity loan as the loan is offered against the equity of your home. But, if you default on your loan, your lender can seize your property into their possession to recover their loss.
Share your thoughts in the comments
Please Login to comment...