Home equity loans (or second mortgages) allow homeowners to tap into their equity. Like primary mortgages, these loans use your home as collateral and typically come with an LTV ratio for additional security.
Home equity loans offer several advantages, such as fixed interest rates and predictable payments, plus possible tax deductions; but you should carefully consider their potential downsides before pursuing one.
Interest Rates
Home equity loan interest rates depend on factors like lender, credit score and debt-to-income ratio. They’re often lower than consumer loans or credit cards but higher than first mortgages.
Home equity loans typically feature fixed interest rates that don’t change over the life of the loan, providing consistent monthly payments throughout the duration. Most lenders allow homeowners to borrow up to 80% of the market value of their home; some offer lower combined loan-to-value (CLTV) limits.
An effective use of home equity loans includes making major improvements or managing high-interest debt. Avoid using your equity loan for luxury expenses that will not add long-term value, like vacations and new cars; prioritize projects that will save money in the future such as paying for college education of children or covering unexpected expenses. Home equity loans usually involve an application process with required appraisal and title searches as part of its application procedure.
Taxes
Home equity loans offer an effective solution to expenses that cannot be covered through personal loans or credit cards, providing lower interest rates than credit cards and tax benefits as an added bonus.
Under current tax code rules, interest on home equity loans and HELOCs is tax-deductible if they’re used to “buy, build or substantially improve” the property that secured them. This definition could exclude things such as paying college tuition or funding a business venture but would include major home renovations like adding an extension or replacing HVAC system systems.
In order to claim this deduction, itemize your deductions at tax time and include all eligible loan-related expenses when totalling them up. However, since 2017 tax reforms more than doubled the standard deduction, this may no longer be worthwhile; to discuss this change with your tax professional.
Requirements
Home equity loans (also referred to as second mortgages) use your house as collateral. If payments are missed on time, lenders have the right to repossess and sell off your property to recoup their losses. To limit this risk, lenders typically require that you own significant equity in your home as well as having excellent credit score to qualify for lower rates. During qualification they will conduct an appraisal of your property as well as request W-2 forms and pay stubs as forms of income verification.
Most lenders limit how much borrowers can borrow to between 80% to 85% of your home’s current value (minus any outstanding mortgage balance), less any existing loans that you currently owe. Most borrowers require at least 620 as minimum credit score requirement – though some prefer higher. Debt-to-income ratio (DTI) will also be an important consideration; aim to keep it below 43% after your potential new home equity loan payment has been added in.
Drawbacks
Home equity loans require using your house as collateral for the loan, meaning if you fail to make timely payments you could risk foreclosure on it. Because this form of financing puts at risk your own home it should only be used for expenses which increase its value or enhance quality of life.
Consider carefully before using a home equity loan for luxury items, such as expensive furniture or vacations. While such purchases might increase the resale value of your home and bring long-term returns on investment, such loans will increase your debt-to-income ratio significantly.
Before agreeing to a home equity loan, it’s also essential that you thoroughly review its terms – such as closing costs and fees – carefully. Consumers can gain an accurate representation of a lender’s rates and fees by reading Loan Estimate forms that must be provided before signing loan documents.
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