When Is Using A Home Equity Loan A Bad Idea
A home equity loan is an ideal tool when you need cash for a justifiable expense. But since a home equity loan is secured by your house, its not a strategy you should use carelessly. For example, it may not be a good idea to take out a home equity loan to fund a lavish lifestyle that is beyond your means, or to take an unnecessary luxury vacation.
Some homeowners rack up too much credit card debt and turn to a home equity loan to pay it off. Thats a great strategyif the borrower plans to better manage their credit card usage and spending habits. If they continue their spending behavior, they might put their home at risk of foreclosure.
Home Equity Loan Alternatives To Consider
A home equity loan can be attractive if youre looking for ways to borrow money, but there are also other ways to get cash if you need it. So before you pull the trigger on a home equity loan, you should also consider the following:
A personal loan lets you borrow a fixed amount of money with a fixed monthly payment and a fixed repayment term. However, personal loans are not backed with collateral, so you dont have to have a specific amount of home equity or any other collateral to use one.
If you dont own a home, or if you dont have enough equity in your house or apartment to be able to take advantage of a home equity loan, a personal loan could be a better option.
If you need to access a line of credit to make some purchases and you dont expect to take more than a year to pay off your debt, you should consider a credit card with an introductory interest rate offer. Many of the top options let you earn rewards on your spending while enjoying zero interest on purchases or zero interest on balance transfers for 15 months or even longer.
Home equity lines of credit
As mentioned earlier, a HELOC works similarly to a home equity loan in that you borrow cash against the value in your home. But a HELOC acts as a line of credit thats available as you need it, and you only pay back the money you take out.
Refinancing your mortgage
When A Home Equity Loan Is A Bad Idea
In general, a home equity loan is a bad idea when it is used for anything other than something that will directly increase your homes value. A home equity loan is a particularly bad idea when used frivolously. Dont use a home equity loan to fund a lifestyle that your income cant sustain. If you cant afford luxury dinners, cars, and vacations on your income, dont erode your homes equity to temporarily live that lifestyle.
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Should You Get A Home Equity Loan
Everyones situation is different, and a home equity loan wont be the right choice for everyone. But if you have unused equity in your house or apartment and you want to tap into it without going through the hassle of refinancing your mortgage, a home equity loan is worth a look. In particular, if you intend to use the proceeds to improve your home, the potential tax deductibility of the interest on home equity loans makes them an option to strongly consider.
What’s The Right Call For You
A home equity loan could make your credit card debt easier to pay off, but if you’re going to go this route, make sure you understand the risks involved. Also, make sure the payment plan you sign up for is one you can afford. If you’re able to keep your home equity loan payments to a manageable level, you can knock out your credit card debt more affordably without putting yourself in danger of losing the roof over your head.
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Reasons To Borrow Using Your Home Equity & Why Home Equity Is Important
Home equity loans are gaining traction because theyre an easy way for you to get money quickly with a low rate. They can allow you to pay off debts, make home improvements and finance new purchases.
For every good home equity decision, there are just as many bad decisions. This guide takes a look at ways you can use home equity to help you stay financially secure, without the fear of losing your home.
Here are five of the best reasons to take out a loan against your home equity.
Pro #: Youll Save On Interest
Often, the number one reason people choose to consolidate their debts is because theyre tired of throwing away hundreds or even thousands of dollars a year on interest. Home equity loans typically have a much lower fixed rate and come with a set repayment period which helps to keep the amount you spend on interest to a minimum. As an added bonus, interest you pay on a home equity loan is usually tax-deductible since its essentially the same as taking out a second mortgage on your home.
A home equity line of credit or HELOC works a little differently in terms of the interest, since they tend to come with a variable rate. The other major difference is that with a home equity line, youre allowed to just make payments towards the interest for a certain period of time. If youre thinking of using a HELOC to consolidate your debt, you want to make sure you get a capped lifetime rate and make payments toward the principal to keep the costs as low as possible.
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Getting A Home Equity Line Of Credit
Even with the risk, a lower interest loan against the equity of your home can be a way to get through this current financial crisis.
The amount you can borrow depends on the current value of your home, how much you owe on your current mortgage, your debt to income ratio, your , and other criteria depending on the lender.
But just because you have been paying on a mortgage doesnt necessarily mean you have built equity. Equity is the difference between what your home is worth and what you owe. It builds over time as you pay down your mortgage.
If youre someone who put zero or 1% or 2% down and just purchased your home recently, you dont have the ability to borrow against it, Carlson says. An interest-only loan could also mean a lack of equity because you have not been paying down the principal, just the interest, she added.
To Pay Off Credit Card Or Other Debt
It is true that a home equity loan will have lower interest rates than credit cards or most other forms of debt. But that doesnt mean its a good idea to use a home equity loan to pay off credit card or other debt. If you havent addressed the factors that caused you to get into credit card debt, youre likely to find yourself in a worse position. You may find that you still dont pay off your credit card each month, and youll also have a home equity loan payment on top of it.
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How Do Personal Loans Work
Personal loans are typically unsecured, so you dont have to provide your property as collateral. Instead, personal loans also known as signature loans are issued based on your creditworthiness. Lenders look at your credit score, credit history, and income when deciding whether to offer you a loan.
Unsecured personal loans are offered by banks, credit unions, and online lenders. You can usually apply for personal loans online and receive a decision the same day you apply. If youre approved, the lender can deposit the money directly into your bank account.
Personal loans have fixed repayment terms, and youll typically make fixed monthly payments for two to seven years. When you apply for a personal loan, youll usually have multiple loan options to choose from, so you can pick the loan term and monthly payment that works best for your financial situation.
Borrowers with lower credit scores may have difficulty qualifying for a personal loan or may find themselves with a higher interest rate. On the other hand, those with excellent credit will likely get better rates and terms.
While a personal loan isnt secured and you wont lose your property if you default, its still important to make on-time payments. Otherwise, the lender can report your late payments to the credit bureaus or send your debt to collections. That can severely damage your credit score and have other consequences.
Down Payment For Another Home Or Investment Property
Lets say you find a sweetheart deal on a second home or investment property but dont have the money to make the down payment, or do not want to wipe out your savings account. If you have enough equity in your primary residence, consider taking out a home equity loan.
Purchasing another home or property via a home equity loan will mean that you must pay a first and second mortgage on your primary residence, plus another mortgage on the new property.
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How A Home Equity Loan Works
Home equity loans are a convenient way for homeowners to pull cash out of their home by borrowing against their equity. When faced with large expenses like a kitchen remodel or wedding, homeowners can contact their mortgage lender or other loan broker and apply for a home equity loansimilar to the process for applying for a HELOC. At closing, the borrower must typically pay fees and closing costs between 2% and 5% of the total loan amount. Some lenders may waive these additional costs.
The resulting home equity loan is secured by the borrowers home, making it secondary to the mortgage. This means that the home equity lender is exposed to more risk because, in the case of default, it wont get paid until the first mortgage lender is paid.
The loan is then disbursed to the borrower as a lump sum, and the borrower must pay interest on the entire balance of the loan. And, because the loan is secured by the borrowers home, the lender can foreclose if the borrower fails to make on-time payments.
On average, home equity loan interest rates start around prime plus 2% however, a borrowers interest rate is ultimately based on several factors like income, employment and credit history. Lenders also consider how much equity the applicant has in their home and their overall debt-to-income ratio, which is the borrowers monthly debt payments divided by their gross monthly income.
Financing Your Education With A Home Equity Loan
Home equity loans are becoming a popular option for funding education because the interest rate can sometimes be lower than student loans. You also have the potential to borrow more. This gives many families an easier way to pay for their own and their childrens education.
It is important to note that some parents may not want to finance their kids education if it would harm their overall financial security. Using home equity to fund education may be a good idea for some, but it can be perilous if youre approaching retirement.
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Invest In Real Estate
When real estate values were surging in the 2000s, it was common for people to borrow from their home equity to invest or speculate in real estate investments. As long as real estate prices were rising quickly, people were able to make money. However, when real estate prices crashed, people became trapped, owning properties whereby some were valued at less than their outstanding mortgages and HELOC loans.
Investing in real estate is still a risky proposition. Many unforeseen problems can arise, such as unexpected expenses in renovating a property or a sudden downturn in the real estate market. And though it’s unclear how the COVID-19 pandemic will affect real estate prices, a rise in value may not be in the near future. Real estate or any type of investment poses too big a risk when you’re funding your investing adventures with the equity in your home. The risks are even greater for inexperienced investors.
What Is Home Equity
Home equity is the portion of your home that youve paid off. Its the difference between what the home is worth and how much is still owed on your mortgage. For many, equity from homeownership is a key way to build personal wealth over time. As your homes value increases over the long term and you pay down the principal on the mortgage, your equity grows.
Equity provides many opportunities to homeowners, as its a great source for savings and for financing, says Glenn Brunker, president at Ally Home. For example, the equity amassed in a starter home may later provide the down payment needed to purchase a larger home as a family grows and needs more space. Its a time-tested way to build wealth.
Home equity is typically used for big expenses and often represents a more cost-effective financing option than credit cards or personal loans with high interest rates.
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Benefits Of A Home Equity Loan
A home equity loan can be a good option if you have a clear idea of how to use the money and are confident you can repay it.
Lower interest rates
While the interest rate on a home equity loan is typically higher than the rate on a primary mortgage, it is lower than the rate charged on unsecured debt, such as a personal loan or credit card.
Fixed interest rates
Youll know exactly what your monthly payments will be throughout the loan term, making this type of loan easy to budget for.
Long payback time
The payback time on a home equity loan can range from 5 to 30 years. The longer the term, the more affordable the monthly payments will be.
Streamline your finances
You can use your home equity loan to consolidate or pay off higher-interest debt, such as credit cards or other unsecured loans.
Pay large expenses over time
You can use a home equity loan to immediately pay large expenses, such as medical bills or home repair costs, but pay back the loan in more comfortable monthly payments over time.
Interest payments may be tax-deductible
If you use the money for home improvements, you may be able to deduct the interest paid on the home equity loan from your taxes.
Home Equity Investment Example
See below for an example of how a home equity investment would work if your home gained value or lost value over time. Keep in mind: The exact numbers will vary depending on your home, location, equity, and the investor you choose to go with.
In most cases, youll need to pay the amount owed at the end of your repayment term or when you sell or refinance your house. One home equity sharing companyUnlockactually allows you to make partial buyout payments, which lets you spread out your repayment over time.
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When A Home Equity Loan May Be A Good Idea
A home equity loan may be a good idea if youre looking to eliminate high-interest debts or meet other financial goals. Many homeowners also use these loan products to make costly improvements to their homes.
However, you should have a stable income to make payments on the loan comfortably. Its equally important that you follow a spending plan each month to avoid overspending. And you want a safety net that can be used as a last resort if you experience financial hardship to ensure you can stay current on your payments.
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What Money Is Used For Is Your Call
Borrowers are checked for their credit worthiness and ability to pay, just as they would be for a first mortgage, he says. The bank will ask what the money is being used for, but the answer won’t change their chance for approval, Block says.
“The usage doesn’t really factor in,” he says.
After home improvements, college tuition and debt consolidation are two other popular uses for home equity loans, Block says. Bank of America promotes responsibility with money, he says, and tries to help customers understand how they can afford their financial obligations.
“One of our overall goals is to make the customer’s financial life better,” he says.
“We always emphasize responsible use,” Block says.
How Home Equity Works
The most common ways to access the equity in your home are a HELOC, a home equity loan and a cash-out refinance.
To tap into your homes equity through one of these options, youll need to go through a process thats very similar to obtaining a mortgage. You can apply through a bank, credit union, online lender or another financial institution that offers these home equity products.
Lenders will consider multiple factors, including a persons debt-to-income ratio, loan-to-value ratio, credit score, and annual income, says Michele Hammond, senior home lending advisor at Chase Private Client Home Lending. Additionally, to determine the amount of equity in a home, a lender will employ an appraiser to determine the current market value of the home, which is based on its conditions and comparable properties in the area.
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