6 Things To Consider Before Taking Out a Home Equity Loan
A home equity loan can turn some of the value you have built in your home into cash without requiring you to replace your existing mortgage.
However, because your home secures the loan, experts recommend looking beyond the available equity and carefully considering the purpose, cost and repayment plan before borrowing.
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1. Know Which Home Equity Product Fits Your Needs
The first step is to decide whether a home equity loan, home equity line of credit (HELOC) or cash-out refinance best matches how and when you need the money.
A home equity loan is a lump sum, typically a second or third mortgage position, according to According to Kenji Inui, broker and CEO of Solve Lending & Realty. "You receive an amount at a certain rate for a set amount of years and it's a fixed payment with no surprises.”
A home equity line of credit is also typically a second or third mortgage, but acts more like a credit card, where you can draw money off of it, as needed, for the first five to ten years, Inui said. “After that, you go to a repayment period of the twenty to twenty-five years left. It's nice because you only pay interest on the money you withdraw.”
2. Make Sure the Expense Justifies the Loan
A home equity loan makes the most sense when the homeowner has a defined, one-time use for the money, stable cash flow, sufficient equity and wants a predictable fixed payment, according to Frederick Blum, licensed mortgage loan originator with Home Loan Advantage, Inc, broker and owner of Blum Realty Group.
“It makes far less sense when it is being used to cover a recurring budget shortfall or lifestyle spending,” he said. However, if it's something that's going to cost you in the long run by not doing proper maintenance, that's something you should absolutely do.
Blum agreed: “Equity should solve a specific problem, such as necessary repairs, an accessibility improvement or another defined expense — not merely postpone an ongoing shortfall.”
3. Test the New Payment Against Your Entire Budget
Do not judge affordability solely by comparing the new payment with the bill or expense the loan will replace. “Test the entire post-loan housing cost,” Blum said as a reminder to borrowers — which includes the first mortgage, new second payment, taxes, insurance, HOA costs, maintenance and adequate reserves. “If that number does not work through a rough financial year, the loan does not pencil.”
With both a home equity loan and a HELOC, you are using your home as collateral, according to Kyle Enright, president of lending at Achieve. “If you miss payments, you are risking foreclosure and potentially losing your home.”
4. Compare Rates, Fees and Total Borrowing Costs
A home equity loan’s advertised monthly payment does not reveal its complete cost. Blum recommended borrowers compare APRs, closing costs, repayment terms and total lifetime interest, paying particular attention to whether the rate is fixed or variable.
Blum laid out the differences: “A home equity loan generally provides one lump sum with a fixed payment. A HELOC offers flexibility but usually carries a variable rate. A cash-out refinance replaces the first mortgage, which can be especially expensive for an owner giving up a much lower existing rate.
Also, a home equity loan typically carries a higher rate than a first mortgage, Inui said, “because in a second or third position it's more risk for the lender, so they charge you for that in rate. And where the rate may be adjustable, in an uncertain market, rates tend to go up a lot faster than they go down.”
5. Understand How Much You Can Qualify To Borrow
Lenders generally evaluate equity, income, credit history and debt-to-income (DTI) ratio. Enright said borrowers can typically access up to 80% of the home’s value minus debts secured by the property, while many lenders prefer a DTI of 43% or less and credit scores of at least 620 to 680.
While Inui said there are “outliers” who might lend outside of these guidelines, a higher credit score is going to typically allow for more borrowing. Though it’s important to remember that qualifying for a certain amount does not necessarily mean the homeowner can comfortably afford to borrow it.
6. Ask Whether the Loan Solves the Underlying Problem
Before you go tapping into that home equity, in whatever loan meets your best needs, "first and foremost find out why you need that money,” Inui said.
Blum wished more borrowers considered “what problem remains after the borrowed money is gone.”
“Your home equity is a great blessing for anyone that bought low and has gained appreciation over time. Don't abuse it,” Inui added.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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