Owning a home is an investment in the future, but only if you know how to take advantage of equity. Equity is the amount of ownership that the property owner has in the house. The easiest way to calculate the equity in your home is to subtract the principal balance left on your mortgage from the current appraised value.
With this equity, you can do several things to improve your financial situation, one of which is taking out a home equity loan.
What Is a HELOAN?
A Home Equity Loan (HELOAN) is a type of loan based on the amount of equity in your home. This loan functions as a second mortgage, with the lender taking a second position as a lienholder on your property behind the initial mortgage lienholder. Home equity loans are often used to pay off other debts or finance more expensive ventures.
When you take out a home equity loan, you receive a one-time lump sum upfront. Then, you will repay the mortgage balance and interest over time, just as you do for the original mortgage. However, these types of second mortgages often have a fixed interest rate, making them a great option for homeowners who need some cash and can afford the additional fixed monthly payments.
How Equity is Used
Your home’s equity serves as collateral for a home equity loan, allowing you to borrow a percentage of its value minus your current mortgage balance. Equity is the difference between your current mortgage balance and the house’s current value. For example, if your home is worth $250,000 and you owe $150,000 on your mortgage, you have $100,000 in equity.
Most lenders will allow you to borrow up to 85% of your home’s appraised value. In this case, 85% of $250,000 is $212,500. Subtracting the $150,000 mortgage balance, you could potentially take out a home equity loan worth $62,500. Your home serves as collateral for this loan, providing security for the lender.
Difference From a HELOC
A home equity line of credit (HELOC) is much different from a home equity loan, even though both are based on your home’s equity. A home equity line of credit is a revolving amount you can borrow against based on the current equity in your home. There are two phases: the draw period and the repayment period.
During the draw period, a line of credit sets a credit limit for how much you can borrow, and you can do so again and again as long as you make repayments. Once the draw period ends, the repayment period begins, during which you repay the borrowed amount. HELOCs often feature a variable interest rate, which can change over time.
In Contrast, a HELOAN provides one lump-sum amount with a fixed interest rate for the life of the loan. You receive the entire loan upfront and make regular, consistent payments until the loan is fully repaid.
How Does a HELOAN Work?
Taking out home equity loans is a great strategy if you can afford the payments that come with them. However, you must be able to qualify for a HELOAN and go through the application process. Here are the steps you will need to follow:
1. Calculate Equity
Determine how much you owe on the principal and subtract that from the home’s appraised value.
2. Find a Lender
Choose a lending firm that provides home equity loans to borrowers.
3. Apply
Follow the lender’s application steps and have information like bank statements, mortgage payments, legal identification, paystubs, W-2s, property details (such as the address and current market value), etc. The loan is subject to credit approval.
4. Appraisal
Your home will need to be appraised by the lender to determine its current value and establish the maximum loan amount.
5. Receive the Funds
You will receive a one-time lump sum payment that can be used for what you need.
6. Repay the Loan
Make regular fixed monthly payments toward both the interest and principal.
What Home Equity Loan is Used For
Why take out a home equity loan? A home is an asset, and property owners can use their assets to take out a HELOAN and use that one lump sum payment to finance other objectives.
Depending on what you spend the money on, the expense could be tax deductible, though you should ask a tax professional for clarification. Here are a few good reasons to take out a home equity loan with a fixed interest rate.
Home Improvement
One of the most common reasons for a HELOAN is to finance home improvements. You may want to complete a big project like a kitchen remodel or a new outdoor living space.
To get the additional funds needed for all the labor and materials, you can use a home equity loan to take advantage of your current equity. Plus, these upgrades will improve the value of your home. Usually, if you spend the funds on the home serving as collateral, the interest on the loan will be tax deductible during the repayment period.
Debt Consolidation
As you build equity in your home, an excellent way to utilize that equity to reach your financial goals is to focus on debt management. Some high-interest debt, such as student loans or credit cards, could be paid off with a HELOAN as a debt consolidation strategy.
Paying off a large debt at once with this loan amount can reduce the total interest you will pay for these higher-interest debts while improving your credit score.
Major Expenses
A home equity loan can provide funds for major expenses. You may want to cover education expenses, pay for costly medical bills, or finance other important expenditures; HELOAN funds can help with that need.
Large Purchases
The funds from a home equity loan can also finance other large purchases. For example, you may want to own a second property to rent out to tenants and need to pay down. Maybe you want a vacation home to visit when you have time off work and need to cover closing costs. The cash from home equity loans can help finance your large purchases.
Emergency Fund
Everyone needs a safety net for unexpected payments, such as home repairs or health-related emergencies. When you need money for a rainy day, a home equity loan that yields a fixed monthly payment can be an attractive option, especially with a fixed interest rate for the life of the loan.
Advantages of a HELOAN
Securing the right loan amount can be incredibly helpful depending on your financial needs, whether financing home renovations or consolidating debt. A home equity loan offers many advantages over other home equity products, like an open line of credit.
Predictable Monthly Payment
Planning a budget is important when you take out any kind of loan. You need to make sure you can afford the new monthly payment going forward. With a HELOAN, you will have a predictable monthly payment for the life of the loan.
Fixed Interest Rate
Your monthly payment will be fixed because of the consistent interest rate. Unlike a line of credit, which usually features a variable interest rate, a home equity loan has a fixed rate that will never change.
Plus, home equity loans generally offer lower interest rates compared to personal loans or credit cards. If you have a strong credit history, you can access a competitive interest rate that will make the repayment plan more manageable.
Access to a Large Sum of Cash
The primary purpose of taking out this home equity loan is to receive a large sum of cash all at once. This cash could reduce your debt-to-income (DTI) ratio, finance a large purchase, build up your emergency fund, or even cover a down payment for an investment property.
Before Getting a HELOAN
Taking out a home equity loan is not suitable for everyone. First, they are subject to credit approval and an income check by the lender, so you may not even qualify. If you can get approved, it is important to understand the risks of a HELOAN.
Risk of Foreclosure
Adding debt means paying more money each month. Even if the cash you receive can fund your other objectives, the additional debt could be too much for you if you have not planned ahead.
If you cannot keep up with your automatic payments, you could risk foreclosure. Because your home serves as collateral for a HELOAN, if you fail to make the loan payments, the loan officer can seize control of your property.
Closing Costs
Whenever you apply for a loan, there will be some closing costs that must be paid upfront or wrapped up into the loan amount. For example, appraisal fees, property insurance, and loan origination fees can affect the final loan amounts when you take out home equity loans. So, always ensure you include those numbers when calculating your budget.
Impact on Financial Health
Before taking on a HELOAN, evaluate if this additional debt is a sound decision and fits your overall financial plan. Will it raise your debt-to-income ratio too high, potentially hindering your ability to apply for other loans? Assess whether it will impact your credit score, making it harder to secure lower interest rates in the future. Additionally, consider the loan’s annual percentage rate (APR) to understand the total cost over time.
Evaluating the impact of a home equity loan is an important step before you consider applying. Perhaps a HELOC would be a better choice with its repayment period and options for interest-only payments at the beginning. It is worth speaking with a tax advisor to understand the implications of your taxes when you take out a home equity loan, especially regarding tax deductibility on what you use the money for.
Alternatives
There are many other options besides home equity products that you can utilize if you need extra money to finance a purchase or consolidate debt. For example, you could take out personal loans instead of using your home as collateral.
If you are looking to purchase a home with a loan, you could consider an FHA or VA loan. For an investment property that will be rented out, a DSCR loan may be a better fit. Make sure you explore all your financing options and analyze the interest payments, insurance premiums, lien position, market conditions, and loan application process before choosing a path.
Summary
When you have enough equity in your home, you can use it to secure a home equity loan (HELOAN) that will help you reach your financial objectives, whether that involves major purchases, debt consolidation, or building an emergency fund. F5 Mortgage is prepared to help you choose your financing path, particularly if you want to take advantage of your home’s equity.
To learn more about home equity loans and how they work, contact our team today by calling 888-459-0483 or filling out this form for a quote. We will connect you with a loan officer so you can discuss your financial goals, your current home’s equity, and how your credit score could impact a potential HELOAN.
