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How home equity loans work: profiles and weaknesses

Home equity loans allow you to borrow according to the value of your home. They provide access to large amounts of money and can more easily qualify for other types of loans as they are provided by your house.

If your home is worth more than it owes you, a home equity loan can offer you the funds for whatever you want – you don’t just have to use the money for home-related expenses. However, using your home to guarantee a loan comes with risks.

A home equity loan is a type of second mortgage. Your “first” mortgage is the one you used to buy your home, but you can use the extra loans to borrow the property if you’ve built up enough equity.

Advantages of home equity loans

Advantages of home equity loans

Home equity loans are attractive to borrowers and lenders. Here are some key benefits of borrowers:

  • Low Rates: Home equity loans typically have a lower interest rate (usually referred to as APR) than unsecured loans such as credit cards and personal loans. Low rates can help keep borrowing costs low, but closing costs can offset low rates.
  • Approval: Home equity loans can be easier to qualify for if you have bad credit. With their home securing a loan, lenders have a way of managing their risk. Therefore, mortgage loans often require extensive documentation, and lenders place minimum requirements that can be difficult to borrow – even if you have significant capital.
  • Big Amounts: Borrowers can qualify for relatively large loans with this type of loan, assuming you have sufficient home equity. For large expenses such as home improvements, higher education, or starting a business, your core capital may be the only source of funds available.
  • Potential Tax Credits: You may be able to deduct some of the interest you pay on a home equity loan, especially if you use the funds for “significant improvements” to real estate. Ask your taxman for details before you borrow and before you claim a deduction.

Lender Security: Most of the benefits listed above are available because home equity loans are relatively safe bank loans: A loan is “secured” with your home as collateral.

If you do not pay, the bank can take over your property, sell and repay your outstanding assets by foreclosing on your home. Moreover, borrowers tend to prioritize these loans over other loans because they do not want to lose their homes. When faced with the choice of missing a mortgage or paying with a credit card, you may decide to skip paying for the card.

Approval is not guaranteed: collateral helps, but lenders must be careful not to pay too much, or risk significant losses. Prior to 2007, it was extremely easy to get approved for a first and second mortgage. Since the housing crisis, things have changed and lenders will carefully evaluate your application. To protect themselves, they try to make sure that you do not take more than 80 percent of the value of your home into consideration given your original home purchase mortgage, as well as any home equity loan you are applying for. The percentage of your home’s availability is referred to as the loan to value ratio (LTV) and may vary from bank to bank – some lenders allow LTV ratios above 80 percent.

Home equity loans are only approved if you can prove that you have the ability to repay. Loans are required to verify your finances, and you will need to provide proof of income, access to tax records, and more.

How a home equity loan works

How a home equity loan works

When borrowing a home equity loan, you can use one of two options:

  1. Lump sum: Take large sums of money up front and repay the loan over time through fixed monthly payments. Your interest rate can be adjusted when you borrow and stay fixed for the life of your loan. Each monthly payment reduces your loan and covers some of your interest expenses (this is a depreciation loan).
  2. Credit Line: Confirm the maximum amount available and just borrow what you need. Known as the Home Equity Credit Line, this option allows you to borrow multiple times after being approved. In the early years, you can make smaller payments, but at some point you have to start making fully amortized payments that eliminate the loan.

To get a loan, sign up with several lenders and compare all lender costs along with interest quotes. Obtain a loan estimate from several different sources, including a local lender, online or national broker, and your preferred bank or credit union. Interest rates may vary from place to place, and you will have to pay closing costs to get a financial loan. Lenders will check your loan, require an appraisal, and it may take several weeks (or more) to release the money. Treat the process as if you are applying for a home purchase: Get your pay and other documents organized to make the process go faster.

How to Find the Best Home Equity Loans?

How to Find the Best Home Equity Loans?

Finding the best home equity loan can save you thousands of dollars or more. To get the best deal:

  • Shop around. Different lenders have different loan programs, and their fee structures can vary dramatically.
  • Manage your credit scores and make sure your credit reports are accurate. If there are errors or issues that are easily solved in your credit reports, use fast dubbing to get quick improvements that can lead to better rates.
  • Ask your network of friends and family they recommend. Ask your local real estate agents which loan originators do the best job for their clients.
  • Compare your offers with those found on websites and ads. Keep in mind that the best rates are only available for borrowers with high credit scores and plenty of income to cover their payments. Carefully read the loan estimate to see if you are paying the same amount you expected.

Additional tips

Is that real credit? Before you borrow, pause and make sure this type of loan makes sense. Is a home equity loan better suited to your needs than a simple credit card or unsecured credit account? If you are not sure, understand this before you turn off your home. These loans may have a higher interest rate, but you can get ahead by avoiding closing costs.

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