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Updated on Thursday, January 17, 2019
If you are a homeowner looking to borrow a hefty sum, chances are you’ve already considered a home equity loan. Home equity loans are granted based on the equity value of your home — that is, the overall value of the property minus the amount owed on your mortgage. Tapping into this equity is a great way to get access to funds for large home improvement projects or financial needs like paying for college, but this option should be exercised cautiously. With your home as the main collateral, foreclosure becomes a serious risk if you fail to pay back your lender. As the borrower, it’s also important to fully understand your loan agreement before you sign, especially in today’s climate of rising interest rates and changing tax laws. Here are a few tips to get you started in the right direction:
1. Consider all options before taking out a home equity loan
Home equity loans are typically the first form of borrowing that comes to mind for homeowners, but it’s good to be aware of other options. Depending on your financial goals, a home equity line of credit (HELOC) might make more sense. Unlike the fixed sum of a home equity loan, a HELOC is a fluid line of credit that allows you to borrow what you want within a credit limit and pay back only what you borrow. It’s a good choice for people who want the option to borrow a large sum without necessarily commiting to the debt up front.
Just like credit cards, HELOCs vary drastically. According to the Consumer Financial Protection Bureau, they usually have a variable interest rate, but borrowers should make sure they understand all stipulations of the loan agreement before signing. These include when they can withdraw funds (ask about a minimum wait period and maximum draw period), additional closing costs and any minimum requirements surrounding the home’s value. If the value decreases significantly, lenders may choose to limit your credit line.
Other borrowing options for homeowners include cash-out refinancing and personal loans. Cash-out refinancing is meant for homeowners looking to lower the interest rates on their mortgage and gain access to additional funds. These typically make the most sense for borrowers who need a significant additional amount and should only be considered when the terms of the new agreement are better than those of the original mortgage.
Keep in mind that all of these borrowing methods put your home at risk and can include significant closing costs. If you only need to borrow a small sum on a short-term basis, you might be better off exploring your options with personal loans.
2. Know tax rules
The Tax Cuts and Jobs Act of 2017 understandably raises concerns for many prospective borrowers, but there are really only a handful of changes that relate to home equity loans and lines of credit.
The first revolves around paid interest and how you can deduct it from your taxes. According to the IRS, the new law states that interest paid on home equity loans and lines of credit is only eligible for deduction if the loans are used to “buy, build or substantially improve” the taxpayer’s principal residence. This means that you won’t be able to deduct interest on a loan used for something like college tuition.
Paid interest deductions are also limited now to homes with mortgages of $750,000 and less, but with the average 2018 new U.S. mortgage of $260,386, this cap isn’t likely to affect the majority of borrowers.
3. Know when long-term debt doesn’t make sense
Once again, home equity loans aren’t the right choice for every borrower. If you’re considering taking out a loan to finance something short-term, like a luxury vacation or clothing, you’d be better off looking into other options that don’t put your house at risk.
4. Know when long-term debt makes sense
Home equity loans and credit lines are better suited for borrowers looking to make long-term investments that add value to their property or create a higher earning potential for their household. This would include things like college tuition and remodeling projects.
5. Keep your total home loan debt below 80%
When it comes to deciding how much money to let you borrow, lenders use what’s called loan-to-value ratio (LTV), which is calculated by dividing the loan amount by the value of your property. While this term usually refers to mortgages, the numbers apply similarly to home equity loans and how much a lender will let you borrow.
In order to qualify for a home equity loan you should maintain a minimum of 20% equity in the home — or said another way, you should always keep your total loan debt below 80%. If your total loan debt exceeds 80%, your lender may ask you to take out private mortgage insurance (PMI). The amount you pay for a PMI will vary based on your LTV and credit score, but ultimately it’s something extra you’ll have to buy to protect the lender — not you.
Another reason to keep your total debt below 80% is to maintain a financial cushion in the event that you suddenly need to sell your home. Using the same logic as the lenders, this ratio ideally would allow you to cut your losses, even in the event that you were forced to sell at a lower amount or with outstanding debts to pay.
6. Shop around
Like anything else, the best way to get a fair loan agreement is to shop around. Ask friends for lender recommendations, and talk to as many of them as you can. Have them go over agreements with you and be sure you understand all of the terms, conditions and fees involved. Once you’ve received a few different loan plans, don’t be afraid to negotiate and make them compete for your business.
According to the Federal Trade Commission (FTC), lenders and brokers have been known to offer different prices for the same loan terms — often because they’re allowed to keep the difference. A good way to start the negotiation process is to ask a lender to write down all the costs of the loan and then ask them to waive or lower certain components. Use a sheet like this one to compare final terms and get the best deal.
7. Have a plan
Don’t wait until your loan agreement is signed to think about the repayment process. Your repayment plan will vary depending on the term and interest rates of your loan agreement. Generally, the longer the term of your loan (or the longer it takes you to repay it), the more you’ll end up paying. Save money on your loans by making a plan to pay them off as soon as possible. By contributing even a little more each month, you’ll end up saving a lot on interest.
Home equity loans are a good resource for homeowners in good financial standing who need funds for a long-term investment. But unlike other forms of debt, these loans could literally cost you your home, and should only be taken out with a solid repayment plan in place.
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