As a homeowner, even if you’re not literally swimming in a bathtub full of cash, you are sitting on a sizable sum of dollars regardless. As your home appreciates in value, your home equity is the difference between its current market value and the amount owed on your mortgage. Extracting that value out of the home without selling it, by way of a home equity loan, can be extremely useful, but is not without risk. Let’s review the pros and cons of home equity loan basics.
A home equity loan is typically provided in a lump sum and repaid over five to 30 years. You will pay a fixed interest rate that is relatively low compared to personal loans or credit cards, since your home is being used as collateral. Once approved, the lump sum offers flexibility to be used as you please, such as for a renovation project, investment property, college fund, or starting a business. Some uses allow the interest payments to be tax-deductible, although you should confirm your specific plans with a tax advisor in advance. Given the fixed nature of home equity loans, they are best utilized not as a slush fund but with a sound plan of what you’ll be spending it on, with some margin for risk tolerance.
Home equity loans are commonly referred to as second mortgages because if you were to lose your home to foreclosure, this lender would be the second-in-line to get paid, after your original mortgage lender. Accounting for this added risk, home equity loans typically have stricter credit requirements, and you must have already accrued significant equity in the home to make it a worthwhile risk for the lender. Typically, this translates to having at least 15 to 20 percent of your property’s value in equity. Since the home itself secures the loan, you risk losing it if you were to default on it and you must be able to cover the balance if you sell it, just as with your first mortgage.
If the home equity loan doesn’t sound like it fits your needs, a home equity line of credit (HELOC) is another option to consider. It opens a line of credit similar to a credit card and allows you to borrow on as-needed basis during the draw period, typically around 10 years. Following that, you’ll enter the repayment period during which you can no longer draw funds. This is a better option if your specific needs are less certain, but risky as they come with variable interest rates that can increase unexpectedly. As with any line of credit, you’re fully responsible for paying off the balance.