Home equity is the value of your house minus what you owe on the mortgage. Home equity can be tapped into as a loan where your home is collateral. This is a commonly used financial tool that could be used to give you a financial edge. If used improperly, it could mess your financial plans for the future. I will explain how to borrow against home equity.
Warning About Home Equity Loans
There is a misconception that paying equity in a home is like putting money in a personal savings account. Home equity is not a saving account with money, but a measure for how much collateral your house is worth. Home equity may literally be value, but it is probably the most illiquid form of value. It cannot be tapped into but used to obtain a loan. It will take time to obtain that loan if you even can.
One of the harshest lessons many homeowners learned from the 2008 recession is that their equity only has value if the lender allows it. There were many situations where homeowners tried to borrow against home equity, but the banks refused to allow them to do so. These freezes are happening at the time this is published due to the pandemic.
The first rule in how to borrow against home equity is you must never borrow for something urgent. The second rule never borrow against home equity for something urgent. Best case scenario the process will be slow. Worst case, the process will not happen.
Requirements To Borrow Against Your Home
There are five general requirements to borrow against home equity:
- You must have at least 15-20% equity – for a home equity loan you need to actually have decent equity to your loan. This never happens if you have less than 15% in equity.
- You need a credit score that is at least in the mid 600s. The higher your credit score the lower the rates.
- Have a low debt/income ratio. You should at most have 43% of your monthly income go towards previously established debt. If your debt/income ratio is above 43% you have already taken on much debt and are a risk.
- Sufficient income. This generally lowers your debt to income ratio. But it also shows you have the capability to pay off the debt. It also determines how much you could borrow.
- Have a reliable payment history. While the credit score can reflect payment history there are many lenders who will look very closely at your payment history. If you have missed payments you could still have a good, or even excellent, credit score. So a lender can refuse the loan based on the payment history even if you have a good credit score.
Types Of Home Equity Loans
There are three types of home equity loans:
- A fixed-rate home equity loan
- A home equity line of credit (HELOC)
- Cash-out refinance.
A fixed-rate home equity loan is a loan borrowed against home equity as a lump sum. For instance, you could borrow tens of thousands or over a hundred thousand. Monthly payments and interest rates are fixed throughout the loan and last until they are paid. Even if you sell your home you will need to pay off your loan.
A HELOC is a loan that works much like a credit card. You have a set credit limit much like with a credit card and you can pay off the balance with some interest if the balance lasts for a certain time. Unlike many credit cards (not all) you will most likely need to pay an annual fee for this type of loan and you will need to take out a minimum. However, many HELOCs require no upfront fee like home equity loans.
A cash-out refinance is where you refinance the house with a different lender, hopefully for a smaller APR. Technically this is not tapping into home equity as much as it is a renegotiation of a mortgage where the equity is taken into consideration. However, unlike other refinancings, you will borrow more than the mortgage for cash. For instance, let’s say you own a house worth $200,000 and have a $50,000 mortgage left, you can refinance the house and borrow $80,000. You will then have $30,000 in cash minus any upfront fees.
Things To Note About Using Your Home As Collateral
One reason many people like to borrow against their home equity is that the interest rate used to be tax-deductible free. That is not the case any longer thanks to the Tax Cuts and Jobs Act of 2017. Now if you take out any home equity loan, the interest is no longer tax-deductible. That advantage is no longer available.
Advantage To Using Your Home As Collateral
A home equity loan is a secured loan, meaning you have collateral. These loans usually have fewer fees and a smaller APR than unsecured loans like credit cards.
For this reason, these loans should only be used for potential investments with high returns of investments or to pay off high-interest rate debts.
Risks To Home Equity Loans
If you are borrowing against your home equity you are going to take a risk on your house. If you do not make your payments you are at risk of losing your house. Make sure to watch the contract you sign because if you borrow against your home equity you are raising a red flag that you are an at-risk borrower. You may be signing a loan that states that even missing one payment could result in foreclosure.
A foreclosure becomes more likely if you have sufficient equity because banks can make more money on a home with higher equity. In order to borrow against your home equity, you need sufficient home equity. Therefore, you are taking a higher risk on your house when a bank may be primed to foreclose.
For this reason, home equity loans should only be used in situations where you need money and have no better option.
If you want to go for a home equity loan you must note the different types. Each loan has different qualities to fulfill your needs. If you need money for certain requirements a fixed-rate loan or a cash-in refinance may be best. If you expect to need money more frequently a HELOC may be desirable.
However, these loans are risky considering the fact that you are using your house as collateral in a situation where your lender may be willing to foreclose. You should only use these loans if you absolutely need money and every other option is less preferable.