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What Is a Home Equity Loan?
The equity in your house, or the difference between its current market value and the amount you owe on your mortgage, serves as collateral for a home equity loan. Similar to a conventional mortgage, the loan is disbursed in one lump sum and is repaid at a fixed interest rate over a predetermined period of time, typically five to thirty years, in equal monthly installments.
While the exact amounts may differ from one lender to the next, most lenders allow you to borrow up to 75% to 85% of your current home equity. Your credit score and payment history will usually determine the amount you qualify for and the interest rate you pay.
You can use the money from home equity loans for a number of things, such as starting a business, paying medical expenses, paying off credit card debt, or financing your education. However, you might be able to write off the interest you paid on the loan when filing taxes if you use the money to build, purchase, or significantly improve your house. According to the IRS, you can deduct interest on qualified home loans up to $750,000, or $375,000 if you’re a married taxpayer filing a separate return.
There is a catch, though: You won’t be able to deduct all of the interest you paid if the total amount borrowed exceeds $750,000 (or $375,000 if you’re married and file separately). These limitations apply to the sum of your regular mortgage plus your home equity loan.
Pros of a Home Equity Loan
Apart from the adaptability of loan utilization and the potential tax deduction on interest paid, a home equity loan can offer numerous additional advantages.
Fixed interest rates remain constant for the duration of the loan, in contrast to variable interest rates that fluctuate. Maintaining constant interest rates can reduce the long-term cost of your loan because interest increases the total cost of your loan. As we’ll talk about below, fixed rates, however, can also be a drawback.
Predictability of payment amounts can be a big plus. Your payment for a home equity loan is set for the duration of the loan and is unaffected by changes in interest rates. You can more easily stick to a budget and project your long-term costs because you know exactly what you’ll pay each month.
Because home equity loans are secured, or backed by your house as collateral, they pose less risk to lenders than other loan kinds. You might therefore be eligible for a lower interest rate than on some other financial products, such as credit cards and personal loans. Naturally, your creditworthiness will have an impact on the rate you get.
You might be able to write off the interest you pay on your home equity loan on your yearly tax return if you use it to construct, purchase, or make significant improvements to your qualifying residence. This is a significant benefit, particularly if you use the savings to improve your house.
Cons of a Home Equity Loan
Home equity loans have advantages, but they also have some significant disadvantages.
Given that your monthly payment doesn’t normally fluctuate from month to month, fixed interest rates can be advantageous. You will, however, be paying the same higher interest rate for the duration of the loan if interest rates decline. As a result, any savings that would result from lower interest rates will be lost to you.
Your credit score is just as important, if not more so, in determining your eligibility for a home equity loan, even though lenders also consider other factors like employment, income, debt-to-income ratio (DTI), credit history, and more. When approving loans, most lenders look for a good credit score in the range of 660 to 700. The lower your credit score, the more likely it is that your interest rate will be. Having a credit score of at least 700 increases your chances of being approved for and paying a reduced interest rate.
Risk of Losing Your Home
A home equity loan uses the equity in your house as collateral. For this reason, you run the risk of losing your house to foreclosure if you default on your loan or miss payments. This is arguably the largest drawback of taking out a home equity loan, so it’s crucial to confirm that you can afford the payments before signing the loan paperwork.
Closing Costs and Fees
Depending on the loan amount, closing costs for a home equity loan can vary from 2% to 5%, or from $2,000 to $5,000 for a $100,000 loan, for instance. There may be origination, appraisal, title search, credit report, loan recording, and other fees. However, loan requirements differ, and some lenders might not charge any fees or closing costs at all. Comparing prices or selecting an alternative loan product could help you avoid these additional expenses.
Alternatives to a Home Equity Loan
A home equity loan is one option if you’ve built up equity in your property to finance a significant purchase, home upgrades, or other large expense. But it is not your only option.
Home Equity Line of Credit
The equity in your house also serves as security for a home equity line of credit (HELOC). It provides greater flexibility than a home equity loan since you can take out smaller amounts as needed or borrow the entire credit limit. Additionally, just like with a credit card, you only pay interest on the amount that you actually withdraw. Generally, you can borrow between 60% and 85% of the equity in your house, depending on your credit score, DTI ratio, and other factors.
Generally, the draw period on a HELOC is 10 years. You can take out as much as you need up to your credit limit during this time. You may only be required to pay interest on the amount you borrow during this period, depending on the terms of your loan.
Your ability to withdraw money stops at the end of the draw period, and you’ll have to pay back the remaining amount on your loan (or refinance to a new loan). Remember that you could lose your house if you don’t repay your home equity loan (HELOC). Additionally, the variable interest rate that most HELOCs have may make it harder for you to budget for your monthly payment.
For a HELOC, in addition to having a significant amount of equity in your house, you must have a credit score of at least 680, though some lenders may demand a score of 720 or higher.
Personal loans can be secured or unsecured. If you are approved for an unsecured personal loan, you won’t have to worry about losing your home, but your credit will still suffer if you don’t make payments.
Personal loans are adaptable and suitable for a wide range of purposes. Repayment terms for them can be as short as a few months or as long as seven years. Interest rates on personal loans are typically fixed, however some also have variable rates. The DTI ratio, employment and income, credit history, credit score, and other factors can all affect rates and repayment terms. Although 670 to 739 credit scores are preferred by most lenders, you might still be able to obtain a loan with a lower credit score.
A cash-out refinance allows you to access the equity in your home to borrow money, much like a home equity loan does.
With a cash-out refinance, you can keep the difference in cash by replacing your current mortgage with a larger new one. Thus, you will only have one loan, possibly with a lower interest rate and monthly payment, as opposed to having two loans, like with a home equity loan. Furthermore, your lender might allow you to borrow up to 80% of the equity in your house.
Even with fair to poor credit, you might be able to get a cash-out refinance because your home is collateral for the loan; however, your chances may be improved with a higher credit score. Additionally, you should anticipate paying closing costs for your new loan in the range of 2% to 6%.
For homeowners who have enough equity in their home and need access to capital, home equity loans can be a good choice. With its fixed interest rates, consistent payments, and potential interest deduction, a home equity loan can be a great substitute for other types of funding. But, there are drawbacks to consider. First and foremost, your home, which is probably your most valuable asset, is at risk because you are using it as collateral.
Additionally, most lenders prefer that applicants for home equity loans have higher credit scores. If you’re not quite there, try raising your score before submitting an application. With Experian, you can check your credit history and score for free at any time.
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FAQ
What is a home equity loan and how does it work?
With a home equity loan, commonly referred to as a second mortgage, you can borrow money as a homeowner by taking advantage of the equity in your house. The loan amount is repaid in monthly installments after being disbursed in one lump sum.
What is the downside to a home equity loan?
Drawbacks of Home Equity Loans: Higher Interest Rate Compared to a HELOC: Over the course of the loan, you may pay more interest since home equity loans typically have higher interest rates than home equity lines of credit. Your House Will Be Used As Collateral: Your credit score will suffer if you don’t make your monthly payments on time.
What is the monthly payment on a $50000 home equity loan?
Example of loan payment: for a $50,000 loan with 120 months at 8 40% interest rate, monthly payments would be $617. 26. Tax and insurance premium amounts are not included in the payment example.
What is the monthly payment on a $100 000 home equity loan?
Example 1: 10-year fixed-rate home equity loan at 8. 75% In the event that you took out a $100,000 home equity loan in 2010 at a rate of 75%, you could anticipate paying slightly more than $1,253% per month for the ensuing ten years.
Read More :
https://www.consumerfinance.gov/ask-cfpb/what-is-a-home-equity-loan-en-106/
https://www.experian.com/blogs/ask-experian/pros-and-cons-home-equity-loan/