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For homeowners looking to tap into their home’s equity for extra cash, a home equity loan could be a good option. However, this type of loan also comes with risks to keep in mind, such as the possibility of losing your home if you don’t meet your monthly payment.
Here’s what you need to know before getting a home equity loan.
What is a home equity loan?
A home equity loan is essentially a second mortgage that allows you to borrow against the equity in your home, which is the difference between the value of your home and what you still owe on your first mortgage. This can help you access extra money if you need it.
How does a mortgage loan work?
Home equity loans are offered by a variety of mortgage lenders. As with most loans, you will generally need good to excellent credit (i.e. a credit score of at least 680) as well as a stable income and a low debt-to-income ratio (DTI) to qualify for a home loan. You must also have sufficient equity in your home, usually at least 20%.
You can usually borrow up to 80% or 85% of the value of your home with a home equity loan, depending on the lender and your financial profile. If you are approved, you will receive a lump sum to use as you wish, for example, to cover major expenses such as home renovations or unexpected medical bills.
Home equity loans come with fixed interest rates, which means you’ll make payments to cover both principal and interest in fixed installments for the life of the loan. Repayment terms generally range from five to 30 years. Keep in mind that lenders generally offer better rates to borrowers who opt for shorter terms.
When to get a home equity loan
Here are some situations that might make getting a home equity loan a good idea:
- You can benefit from a good interest rate. Since a home equity loan is secured by your home and therefore less risky for the lender, it usually comes with a lower interest rate than you would get with a personal loan or mortgage. unsecured credit card. If you have a good credit score, you’ll be more likely to qualify for the lowest rates available, which will reduce the overall cost of your loan.
- You know exactly how much you need to borrow. Unlike a home equity line of credit (HELOC), a home equity loan is paid out in a lump sum. It might help if you know exactly how much you need to borrow.
- You want stable payments. Since home equity loans come with fixed rates, your payments won’t fluctuate like they might with a variable rate HELOC or credit card.
- You will be entitled to a tax deduction. According to the IRS, you can deduct the interest on a home equity loan from your federal income tax if you use the funds to “buy, build, or substantially improve your home.”
When not to get a home equity loan
Although a home equity loan can be a good option in some cases, getting one comes with several risks that are important to be aware of. If you’re considering a home equity loan, here are some scenarios where it might be best to look at other alternatives:
- You could risk losing your home. In addition to the amount you still owe on your first mortgage, taking out a home equity loan means you’ll have another large loan to pay off at the same time. And like with a typical mortgage, your lender could foreclose on your home if you don’t make your payments. If you doubt you’ll be able to handle two loans, don’t get a home equity loan.
- You will have to pay high closing costs. As with your first mortgage, you will have to pay closing costs if you take out a home equity loan. These can range from 2% to 5% of your loan amount, which could significantly eat into your cash reserves.
- You don’t know how much you need to borrow. If you end up needing more money than you borrowed with a home equity loan, you will need to apply for another loan. In this case, it may be better to opt for a revolving line of credit that allows you to borrow repeatedly, such as a HELOC.
- You plan to sell your house soon. If you decide to sell your home, you will need to make enough profit from the sale proceeds to pay off both your first mortgage and your home equity loan. This could leave you with very little, if any, cash proceeds from the transaction.
Alternatives to a home equity loan
Here are some alternatives to consider if a home equity loan isn’t right for you.
- HELOC: Unlike a home equity loan, a HELOC is a revolving line of credit that you can draw on and repay repeatedly. This could be a good option if you have a long project with fluctuating costs to cover. Keep in mind that like a home equity loan, a HELOC is secured by your home and you risk foreclosure if you don’t make your payments.
- Personal loan: With a personal loan, you can usually borrow up to $100,000, depending on the lender. Most personal loans are unsecured, which makes them less risky for the borrower than a home equity loan. However, the tradeoff is that you’ll likely get a higher interest rate.
- Credit card: Another revolving line of credit option is a credit card. Some cards come with an introductory annual percentage rate (APR) offer of 0%, which means you could avoid paying interest if you pay off your card before the end of that period. But if you can’t pay off the card on time, you could end up with high interest charges — and credit card interest rates are generally higher than home loan and personal loan rates.
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