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Updated on Thursday, January 24, 2019
As a homeowner, each mortgage payment you make helps build equity in your home. Equity is the difference between your home’s current value and the amount you still owe on your mortgage.
Some borrowers decide to tap into their equity to fund a remodeling project, pay medical bills or cover another large expense. One way to do so is through a home equity loan.
In a home equity loan, you’ll get a lump sum amount of money upfront, usually with a fixed interest rate. This sets it apart from a home equity line of credit, or HELOC, in which you have access to a source of funds you can draw on as needed. With a HELOC, you only pay interest on what you borrow, and many HELOCs have variable interest rates. In those ways, a HELOC works similarly to a credit card.
In either case, the loan or line of credit is secured by your home. If you can’t pay back the loan, you could lose your house to foreclosure.
Home equity loans, also known as second mortgages, have a fixed interest rate, so you will be responsible for paying the same amount of money each month throughout the loan’s term. In this way, it’s similar to how you pay a fixed-rate mortgage.
The size of the home equity loan depends on the equity you’ve built up in your home. While the terms vary depending on your income, credit score and other factors, you may be able to borrow up to 85% of the equity in your home.
Most home equity loans have terms of five, 10 or 15 years. The longer the term, the lower your monthly payments will be. It’s important that you get a term length that’s long enough that you can afford the monthly payments. Keep in mind, though, that the longer the term, the more interest you’ll pay.
Pros and cons of home equity loans
Why opt for a home equity loan rather than taking out a personal loan, or using a credit card? It often comes down to interest rates. Rates are typically lower with a home equity loan because it’s a form of secured debt. The loan is secured by your home.
The biggest downside is the potential to lose your home if you’re unable to make payments. Because you’re securing the loan with your home’s equity, that puts you at risk of foreclosure.
In addition, you will have to pay closing costs, just as you did with your mortgage. These include fees for an attorney, application, filing and preparation, appraisal, title search and more. Closing costs for home equity loans typically end up costing 2% to 5% of the loan’s total.
Home equity loan term ranges
Home equity loans have a fixed term, typically five to 15 years. You won’t usually be able to secure a term shorter than five years because a shorter term would make for very large monthly payments.
But just because you settle on a certain term — say, 15 years — doesn’t mean you’re necessarily required to be paying off the loan for all 15 years. If you have the cash flow, you may be able to pay off your home equity loan faster than the full term, which saves you on interest. Just be sure to check whether your loan has a prepayment penalty — a fee some lenders charge if you pay off a loan early.
Home equity loans usually have lower interest rates than personal loans or credit cards, which are unsecured debt. For example, average APRs for home equity loans have recently hovered at 4% to 6%. Rates for personal loans, on the other hand, have averaged between 6% and 36% APR. Credit cards have an average between 16.75% and 23.62% APR. Whenever you’re taking out a loan, it’s important to compare rates across various lenders to be sure you’re getting your best deal. The difference can be thousands of dollars over the years.
You may find that a longer term is better for your budget. If your loan is spread out over a longer time period, you’ll have lower monthly payments, which could free up money for other spending or financial priorities. This can make sense if you’re taking out a significant amount for a project like remodeling your home, for example.
However, the longer the loan, the more you’ll end up paying in interest. This is the balance you want to strike as you consider your term.
Another important thing to know is that if you sell your house, you’ll have to pay back the home equity loan immediately.
If you’re looking to pay back the loan over a term of longer than 15 years, you might want to consider a cash-out refinance, which may have a loan term as long as 30 years. A cash-out refinance is when you take out a new home loan for more than you owe on your current mortgage. You then get the difference in cash to use mostly at your discretion. After you close on the loan, you will pay off the new mortgage according to the new terms and monthly payment amounts.
To be approved for a cash-out loan, you must have equity built up in your home to qualify. Your lender will also look at your credit score to determine if you’re creditworthy enough to pay back the loan. In addition, they’ll consider your debt-to-income (DTI) ratio, which is your total monthly debt payments divided by your monthly gross income. This shows that you can afford the monthly payments.
Another important factor is the loan-to-value (LTV) ratio. This is the ratio between the value of your home and the value of the loan. You won’t qualify for a loan that exceeds a certain share of the value of your home.
You may find that a cash-out refinance is a better option than a home equity loan because you can have a longer loan term. You’ll benefit from having your payments spread out over a longer time frame, making each payment more manageable. In addition, you may benefit if you can get a lower interest rate on the refinancing than you had on your original mortgage. It wouldn’t make sense to do a cash-out refinance if your interest rate will be a lot higher.
However, it’s important to consider the potential downsides of refinancing. Since you’re taking out a new mortgage, you’ll face closing costs higher than you would with a home equity loan. You’ll also want to know how much equity you’d be left with on your property. If the refinancing leaves you with less than 20% equity, you may have to buy private mortgage insurance, or PMI.
Home equity loans can be a good tool if you’re looking for a lump sum of money to complete a major project or pay off credit card balances. However, it’s important to be sure you’re not tapping into your home’s equity without having a strong financial plan to pay back the loan.
Part of that planning process will include considering the length of the loan. Choosing the right length will ensure you have manageable monthly payments while not paying more than you need to on interest.
If you opt for cash-out refinancing, do your research to make sure it’s the best option for your situation. No matter whether you choose a home equity loan or cash-out refinancing, be sure to shop around to make sure you’re getting your best interest rate.
Using your home’s equity to secure a loan can be a smart financial decision, provided you go about it wisely. Choosing the right loan term for your budget is an important part of this decision. By doing your homework and considering all your options, you can rest assured you’re making savvy decisions for your financial future.