Life is full of surprises, and not always good ones. If you are in a situation where you need a large amount of money to cover a big expense, then choosing to tap into the equity of your home can be a wonderful option. One way to do this is by acquiring a home equity loan. In this article, we will go over the ins and outs of home equity loans, how they work, and how you can qualify for one.
What is a home equity loan?
Home equity can be defined as the portion of your home that you have paid off – your stake in the property, as opposed to the lenders. In most cases, home equity builds over time so you can pay down your mortgage balances or add value to your home.
You have may heard of people taking out a second mortgage on their home because that is essentially what a home equity loan is. It is a loan that allows you to borrow against the value of your house. At Welch State Bank, we often hear customers want a home equity loan in order to cover home improvements, medical debts, or even to cover educational costs.
Home equity loans are attractive forms of loans because they are typically available at lower interest rates than credit cards or personal loans. Lenders feel comfortable offering you lower rates because they know that if you stop paying these loans, they can foreclose on your house.
How do home equity loans work?
Home equity loans work the same way your mortgage did when you initially bought your house. The money from the loan is disbursed in a lump sum to you, allowing you to use it as you need to. After receiving the money, you will start making fixed, monthly payments in order to pay back the loan.
What are the benefits of using home equity loans? What are the drawbacks?
Home equity benefits are simple and straight forward. They have benefits such as lower interest rates as well as tax benefits that allow one to deduct mortgage interest on home equity loans or lines of credit.
The drawbacks to home equity loans are the borrowing costs. Make sure you pay attention to the annual percentage rate (APR), which includes your interest rate plus other loan fees. Another drawback to home equity loans are the long-term risk of losing your home if you fail to make your payments and then foreclose on your home. Additionally a disadvantage to home equity loans is the ability to misuse the money. It’s important to stick to a financial plan that ensures you do not live beyond your means.
How do you build home equity?
Home equity is the difference between your home’s current market value and your mortgage balance. With that said, there are ways in which you can increase your home equity.
- When you make your mortgage payments every month you reduce the outstanding balance on your mortgage, thus building home equity. You can also make additional mortgage principal payments to help you build equity faster.
- When you make home improvements, you increase your property’s value which works to increase your home equity. If you are interested in learning more about what home improvements increase your property’s value, feel free to check out our blog, 5 Home Improvement Projects for Added Resale Value.
- When property value rises, your equity rises too!
How do I qualify for a home equity loan?
Qualifying for a home equity loan is a similar process to qualifying for your first mortgage. If you don’t remember much about the process from buying your first home, feel free to check out our article called What to Expect When Buying Your First Home. Your lender will want documents from you such as proof of employment, as well as records of your debts and assets. They might also ask for you to have:
- Two years’ worth of W-2s or tax returns.
- Your most recent pay stub, with year-to-date income listed.
- Statements for all bank accounts and assets.
- Debt records for any credit cards or other loans.
Your lender’s job is to take the information you have provided them and discover how much equity you have in your home, which is the percent of your home that you own outright. This equity will allow you to determine how much money you can borrow. Most lenders only allow you to borrow up to 85% of your home’s equity.
To find out how much that is, follow this equation:
- The amount of your home is worth X the percentage of home equity you are allowed to borrow – how much you still owe on your home.
For example, if your home is worth $200,000 and you are allowed to borrow up to 85% of your home equity, but you still have a $100,000 balance on your mortgage.
- $300,000 X 0.85 = $170,000
- $170,000 – $100,000 = $70,000
- In this case, you would be approved for a $70,000 loan
Before applying for your loan, we suggest having figures written down for how much you want to borrow, and what you want to use the money for. Only borrow as much as you need because you will be paying for this loan over an extensive-term.
What is the difference between a home equity loan and a home equity line of credit?
Home equity loans and home equity lines of credit are often confused. They are similar solutions in that they both let you borrow against the value of your home, but they are in fact very different from each other.
A home equity loans function like traditional mortgages, whereas a home equity line of credit works like a credit card. Home equity lines of credit typically give you a period of time you can draw equity for your home, and also have adjustable interest rates.
If you’re not sure which is right for you, the loan officers at Welch State Bank would love to talk to you. They can help you discover which will best suit your needs.