Why a Home Equity Loan

Highlights

  • Understand why lenders have toughened qualifying standards for home equity loans.
  • Review some advantages of borrowing on your home equity.
  • Examine some of the risks of touching your home equity.
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Why a Home Equity Loan

You may choose to take out a home equity loan for a variety of reasons. You may want to pay for a home-improvement project, consolidate some high interest debt, pay for college costs for a child, cover some large medical costs, or want to finance a big-ticket item purchase.

Harder to Qualify for a Home Equity Loan

In order for you to qualify for a home equity loan, you need to be in a strong equity position. Lenders have stiffened their requirements for home equity loans, in response to the mortgage crisis of the past few years.

Most lenders will not lend you more than 85% of the value of your home. Lenders look at the fair market value of your home and compare it to any loans you currently have, as well as the home equity loan you want. The total principal balances of all loans divided by the value of your home makes up your combined loan-to-value (CLTV).  Most home equity lenders will not go above 80-85% CLTV.  

It used to be that a borrower with a strong equity position could take out a home equity loan even with a bad credit rating. Now, most lenders require the borrower to meet stringent qualifying rules regarding credit, income, and equity position.

Home equity lenders are worried about the risks of making home equity loans, as the loan falls into a second or junior position. This means that the lender has to get in line behind the first mortgage holder, if your home goes into foreclosure. With the fall in home values across the nation, second mortgage holders have often found themselves unable to collect, when the borrower defaulted. The house value often fell below the level where even the first mortgage could be paid, leaving the home equity lender exposed to heavy losses. This has caused some home equity lenders to restrict their loans to borrowers who have a first mortgage with them.

Home Equity Advantages

An advantage of home equity loans is that they offer a lower interest rate than almost any type of unsecured loan. If you do not want to refinance your primary mortgage, for whatever reason, a home equity loan likely offers you a far lower interest rate you would find on an unsecured loan.

A home equity loan is superior to borrowing on a credit card, for a number of reasons, even if the credit card advance comes with an initial low interest rate or low fees.  One missed payment on a credit card exposes you to default interest rates, which can be as high as 35%. If you miss a payment on your home equity loan, the penalties are nowhere near as costly.

Home equity loans can be divided into two categories, standard Home Equity Loans (HELs) and Home Equity Lines of Credit (HELOCs). It is possible to get either type of home equity loan with a fixed rate or one with a variable rate.  Variable rate loans will come with a lower rate, but you are exposed to a rise in your monthly payment, sometimes severe, if rates rise significantly.

HELs are usually taken when you want to finance some major, one-time purchase, where you know what your total costs will be, such as a home improvement project with a fixed budget. HELOCs are ideal for purchases or expenditures where the costs will be spread out over time, such as paying college costs at the beginning of each college year.

If you do not want to refinance your first mortgage, a home equity loan can be a great option. You likely will have lower closing costs than in a first mortgage refinance. You can use the money for any need you see fit, giving you a low-cost option to pay down other debt or to finance a large purchase.

Exercise Caution when Touching your Home Equity

Always be cautious, when touching your home equity. Remember, if you default on a home loan, you risk losing your home. Also, reducing your equity stake at a time when house values can continue to fall is also risky. It can leave you with total obligations against your home that are greater than your home’s value. This can make it hard to sell your home, if you need to relocate or sell your home due for any reason.

Be a careful consumer.  Look at all your options, weighing the good and parts carefully, before making any major financial decisions.

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