If you’re a homeowner, you may have considered taking out a home equity loan to help pay for a big expense, from a home renovation to your child’s college education. But what exactly are home equity loans, and what do you need to know before borrowing with one?
What is a home equity loan?
Home equity loans allow you to make use of some of the value you have invested in your home. Every month that you make a mortgage payment, the equity you hold in your home grows. While you may feel poorer when the mortgage payment check clears the bank, you aren’t. You’ve simply converted one asset-cash-into another-increased equity in your home. The only expense you incur is the interest portion of your mortgage payment. Therefore, as you reduce the balance owed on your mortgage, your personal wealth grows.
Unlike liquid assets, such as money kept in a checking or savings account, you can’t just make a withdrawal from your home when you need extra funds. However, a lender can make the funds you have tied up in your home accessible to you by issuing a home equity loan.
Because they pose a lower risk for the lending institution, home equity loans typically carry lower interest rates than unsecured personal loans. The current national average annual percentage rate (APR) for a home equity loan is approximately 5 percent. However, a home equity loan is essentially a second mortgage in which your home serves as collateral. If you default on the loan, you run the risk of foreclosure and potentially losing your home.
What are the best uses for a home equity loan?
With terms ranging between five and 20 years, home equity loans can be a great option for paying college tuition, consolidating higher-interest debt, adding a pool or remodeling your home. An added benefit of using a home equity loan to improve your home’s value is that the interest payments may, in some cases, be tax-deductible.
How much can you borrow?
Most banks will lend up to 80 percent of your equity. When you apply for a home equity loan, the lender will send an appraiser to determine your home’s value. (This amount is not the same as the market value, which is determined by the housing market at an any given moment.) The appraiser will consider the home’s features, age, size and the neighborhood in which it’s located to determine a value.
From that appraised value, the lender will deduct the amount you still owe on your home to determine your equity. For example, if the appraised value of your home is $200,000 and the principal balance on your mortgage is $120,000, your equity is $80,000. To calculate the maximum amount you may borrow against your home, multiply this your equity by 80 percent-which, in this example, is $64,000.
How much should you borrow?
You do not have to borrow all the way up to your maximum limit. And it is never advisable to take on more debt than you can comfortably handle. If you are unsure of what you can afford, draw up a realistic budget. A rule of thumb is to keep your debt-to-income ratio -your monthly debt payments divided by your gross monthly income-at or lower than 50 percent.
A reputable financial institution will not lend you more money than you will be able to pay back. If a lender approves you for an amount greater than your budget says you can afford, it’s a good idea to approach that lender with caution.
How to shop for the best home equity loan
Finding a low annual percentage rate will naturally be a top priority when comparing home equity lenders, but you need to examine each institution’s terms to determine which home equity loan will work best for you.
When shopping for a home equity loan, ask these questions:
- Is the interest rate fixed or adjustable?
- If it’s adjustable, is there a cap?
- What fees, if any, will I be charged?
- Will a late payment cause my interest rate to go up?
- Is there a prepayment penalty?
Does the loan proposal include credit insurance?
If you don’t want credit insurance, ask that it be removed from the proposal.
Before signing a loan agreement, carefully read the document to ensure you understand the loan terms. The decision to put a lien against your home should be deliberated with care. Do not feel compelled to sign anything immediately. You may wish to take the agreement with you and go over it with a financial advisor before signing.
If you’re shopping around for a home equity loan, start with us. Our low, fixed rates*, convenient online payment options and team of real estate experts will help you get the most out of your home.
*Equal Housing Lender. Certain restrictions apply. All loans are subject to credit approval. See credit union for details. City Credit Union is federally insured by NCUA.