From paying down those credit cards to making a major purchase, like a new car, a home equity loan could be a good source of funds. But because you’re borrowing against your home, you should know what exactly you’re getting into. Here’s a look at the basics of home equity loans.
What is a home equity loan?
With a home equity loan, you borrow against the equity you’ve built up in your house. Put simply, equity is the value of your house minus what you owe on it. So, if your house could sell for $160,000, and you owe $100,000, you have $60,000 in equity. The total amount you can borrow is based on the loan-to-value ratio (the ratio of any loans using your house as collateral to the value of the house) allowed by your lender.
So, if your house could sell for $160,000, you owe $100,000, and the loan-to-value ratio allowed by the terms of your loan is 80%, you could borrow up to $28,000. Here’s the math:
Home Equity Loan Example
|Market value of home||$160,000|
|Loan-to-value ratio set by lender||80%|
|Percentage of market value = Market value of home x Loan-to-value ratio set by lender||$128,000 = $160,000 x .80|
|Maximum home equity loan amount = Percentage of market value – Mortgage balance||$28,000 = $128,000 – $100,000|
This example is for demonstration purposes only.
Whatever you borrow with a home equity loan, you get in one lump sum and pay it back over the term of the loan (usually two to 15 years).
A home equity line of credit is similar to a home equity loan in that you borrow against the equity you’ve built up in your home. This revolving loan will allow you to make large purchases, pay them off, and maintain your equity credit line for the next purchase, similar to a credit card.
Is it right for you?
You can use the funds from this kind of loan to pay for a variety of expenses. Some customers use them to:
- Pay off credit card debts with higher interest rates than their home equity loan
- Make home improvements
- Make a large purchase such as a car
To help determine if a home equity loan is a good option for you, ask yourself the following questions:
- How’s your credit? Borrowers generally have to have excellent credit scores in order to take out a home equity loan. For more information on credit scores, see “Credit scores: A digital finger on your financial pulse”
- How’s the market? Check out comparable homes in your area, or consult a Realtor®. If homes like yours are selling for more than you owe, it might be the right time. If not, you might want to wait for a more favorable market.
- If you’re planning to make a home improvement, will your purchase increase the value of your house? Upgrades like new kitchens or bathrooms almost always add value, but cosmetic changes don’t necessarily make a house more attractive to buyers. You might consider talking to a Realtor before you borrow.
Home equity loans also offer benefits that could make them an attractive option for you:
- The interest paid on home equity loans is tax deductible.
- Interest rates for home equity loans are typically lower than rates on credit cards and other consumer loans.
Finally, before you take out a loan, take some time to evaluate your finances and decide how much you can afford in loan payments. If you can’t pay your home equity loan back, you might be forced to sell your house. Alan Stoltenberg, vice president of mortgage and business services at SAC Federal Credit Union advises, “You certainly want to make sure you are comfortable with the added payment in combination with your overall financial picture. Your loan officer can help you determine acceptable debt-to-income ratios, although the payment needs to be comfortable for you and your family.”
Have you taken out a home equity loan? How did you decide if it was the right option for you?