One of the most persistent myths about buying a home is the notion that you need to, or at least should, put 20 percent down. The truth is, you don't need anywhere near that much.
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Home Equity Loans
By Kirk Haverkamp
Updated and reviewed Nov. 26, 2014
If you’re a homeowner in need of money, and have accumulated equity in your property, you may be able to convert this equity into cash. People choose to draw on their home equity because loan rates are significantly lower than other types of borrowing, like personal loans or credit cards. There are also tax advantages associated with home equity loans, because the interest may be tax deductible within certain limitations. Another reason that home equity loans are appealing is that closing costs are relatively low.
Home equity loans are also known as second mortgages because they are subordinate to your primary mortgage. If you can’t afford to make your mortgage payments and subsequently default, the first mortgage gets paid off first from any proceeds of a sale. As a result, there is much more risk for lenders who give you a home equity loan.
Understanding the different types
There are two types of second mortgages the home equity loan, which is also known as a HEL, and the home equity line of credit, which is also called a HELOC.
A home equity loan is a fixed-rate loan, where the lender will give you a lump sum of money, and you pay it back during a specified period of time. Payments are higher than they would be with a HELOC, because each month, you’re paying interest and principal. They are most appropriate if you’re borrowing for a project where you know exactly how much money you’ll need, and you like the consistency of a steady monthly payment. One great advantage of a HEL over a HELOC is that you will continue to build equity in your home each month as you pay the loan back.
A HELOC offers much more flexibility than its second mortgage counterpart. A lender will give you a line of credit, which you can draw from on an as-needed basis. It functions a lot like a credit card, except that the interest rate is lower. HELOCs have a variable interest rate that is tied to an index, like the prime rate or the LIBOR, and will change every month. You’ll be allowed to take money out during the draw period, which is generally about 10 years. Most banks allow you to pay interest only during the draw period. However, if you choose that path and don’t pay down your principal, it will continue to accumulate. At the end of the draw period, you’ll be required to pay back any remaining principal either as a lump sum, or on an amortized basis, and will no longer be able to withdraw any additional funds.
There are some major drawbacks with HELOCs. One is that if you make payments of only interest, you’re not building any home equity. The second is that, because the interest rate is variable, you have no idea how to budget for the HELOC expense.
How much can you borrow?
Most banks will allow you to borrow up to 80 percent of the available home equity in your property. To calculate that amount, determine the current value of your home. Your next step is to subtract the value of your current mortgage. Divide the number by 80%, and bingo … you now have the maximum amount of home equity that you may be qualified to borrow against.
Setting Your Limits
The HELOC limit depends on how much equity you own in your home. Let's say the house appraises at $200,000. If your first mortgage balance is $80,000, your equity is $120,000. A second loan that's secured by this equity, such as a home equity loan or a home equity line of credit, can usually have a credit limit as high as 80 or 90 percent of this equity. For our example, we'll opt for a 90 percent HELOC, which would enable you to apply for a maximum credit line of $108,000.
One very important thing to remember is that a home equity line of credit is not a traditional loan. You don't apply for a loan amount, technically speaking, but rather for a credit limit. Once the credit line has been approved, you can treat it like a credit card. Borrow the money when you need it, and replenish it when you can. In the meantime, all you need to pay is interest on the amount you borrow. You're under no obligation to borrow every last cent of that line of credit-though you can if you need to.
How To Use Your Credit
It may be best to simply apply for the maximum amount that you qualify for. This way, you have a cushion to protect you in case of emergencies. You may not need all of that money now, but it's there if you need it later. Closing costs for HELOCs are minimal. However, many states require that you pay a one-time mortgage tax at closing. The higher the credit line, the higher the tax. As a result, you may not want to opt for the maximum amount.
There also may be direct benefits to establishing a high credit line, even if you don't plan to use most of it. Credit bureaus like seeing lots of available credit that you haven't used. A largely unused HELOC may, therefore, improve your credit score.
Advantages and disadvantages of home equity loans
Both home equity loans and HELOCs offer several advantages when compared to other types of borrowing. First, the application process is much quicker than with a traditional loan. Some banks may even approve you on the spot if you don’t want to borrow too much and you have a good credit report.
Second, home equity loans can be amortized for up to 30 years, which can make your monthly payments much easier to manage. Third, interest is generally tax-deductible, and interest rates are lower than with other comparable borrowing opportunities. Finally, if you have a large amount of equity accumulated in your home, you have access to a significant sum of cash.
So far, everything sounds good. But there are many risks associated with home equity loans. The biggest drawback is that if you can’t make your payments, a bank could foreclose on your property. If you make late payments, you may be hit with hefty fees. Banks will report your tardiness to the credit reporting agencies, and your credit rating could take a big hit. And even though mortgage rates for home equity loans are lower than credit card rates, they will be significantly higher than rates for traditional mortgages.
Another risk that’s associated with HELOCs is that when the rate adjusts, you may not be prepared for the higher payments. Say, for example, that you borrow against your line of credit to send your child to college when interest rates are low – in the 4 to 5 percent range. Then you find yourself in an environment where interest rates are rising, and you’re now paying 7 to 8 percent interest. If you’re not prepared, you could find it difficult to make the higher monthly payment.
Finding the best home equity loan
Shopping for a HEL or a HELOC is just like shopping for any other item – you need to speak to a variety of different sellers to see who’s offering the best rates and the lowest costs for your needs. Don’t forget to check with the bank where you have your first mortgage or any other banking relationship, because many banks give discounts to established customers. Some will extend the discount to you if you open a checking or savings account at the time of your home equity loan application. Also, don’t neglect checking with your local credit union. They may waive costs for members, and some offer slightly lower rates than traditional banks.
Tips for getting the best home equity loan you can qualify for.
- Pay off debts before applying. This will raise your FICO credit score. A higher score can get you a lower rate.
- Don’t borrow more than you need, even if you qualify for more. The more you borrow on a home equity loan, the more interest you’ll pay. With a HELOC, you may be tempted to draw more money than you really need, just because it’s available.
- Don’t say yes to the first offer. Even if you think the rate and terms are amazing, it pays to shop around with other lenders. You can also use your first offer as leverage to see if another bank will meet or even beat it.
- Know what you’re getting into. Take the time to upgrade your mortgage vocabulary. You’ll be a lot better off if you understand terms like spread, LIBOR, amortization, floor, and ceiling when you talk to prospective lenders.
- Get it in writing. Lenders may quote you rates over the phone, but unless it’s written down, it’s no guarantee. Once you submit your application, the lender will send you a quote that contains all the terms of your loan. Read it carefully, to confirm that it’s exactly what you applied for.
- Understand the differences between a Home Equity Loan and a HELOC. For example, home equity loans are usually fixed-rate, while HELOCs are usually adjustable-rate loans. That can make a big difference when it comes time to start paying them back.
- Avoid prepayment penalties. Paying down your mortgage ahead of schedule can save you money, as long as you don’t get hit with prepayment charges. Whenever possible, try to get a loan with no prepayment penalty so you won’t get hit with extra charges if you pay if off early.
- Know your terms. This is particularly important with a HELOC, since the terms will dictate how your rate varies over time. Make sure you know which index your rate is tied to, what the margin is and how frequently the rate will adjust. Most important, know your “life cap” – the maximum your interest rate can increase over the life of the loan.
Home equity loans offer tax advantages – but if you don’t fully understand how they work, you can get in big trouble with the IRS.
The most important thing to know is that, according to IRS rules, there are two types of mortgage debt – home acquisition and home equity. Your home equity loan can fall into either category, depending on what you do with the money. When you use it for home-related expenses, like buying, renovating, or constructing a residence, you can call it home acquisition debt. When you use the money for any other purpose, it’s home equity debt.
You’re allowed to deduct mortgage interest on up to $1 million of home acquisition debt, but only up to $100,000 of home equity debt. But it’s not all that straightforward – there are additional limitations. First, you’re not allowed to deduct interest on home equity debt that exceeds the market value of the home. Second, once you hit $1 million in home acquisition debt, the rest will count as home equity debt. Third, if you and your spouse file separate tax returns, both limits are halved. Finally, all these limits apply to the total mortgage debt, regardless of how many homes or mortgages you own.
Even if you clearly understand these rules, it’s a good idea to check with your tax advisor or professional tax preparer. The Tax Code is complicated, and making a simple error on your home equity deduction could activate a red flag for an audit on your entire return.
During the mortgage crisis, many people decided to stop paying their mortgages. Defaulting on your home equity loan can have far-reaching consequences, and it’s ill advised. If you fall behind on your payments, or skip them, your lender could take action. The first step it may take is to give you additional time to find money for the missed payments. But if the lateness continues, you will leave no choice for the bank but to take legal action.
It may be a modicum of good news for you that the second lien holder is not able to foreclose on the property without paying off the first mortgage holder. However, if you have accumulated substantial home equity, the lender could sell your property, and pay off both loans with the proceeds of the sale. It’s more likely, however, that there wouldn’t be enough equity if you find yourself in this predicament, so your lender has two other choices work with you on a forbearance plan, or negotiate a settlement.
A forbearance plan is a temporary reduction of your monthly payments. If you’re undergoing a short-term challenge, this may be the best choice. However, your interest will generally accrue during this entire period and, once the forbearance period is over, you may be required to make larger payments to make up the difference.
If your problems are greater than a short-term reduction would solve, your lender may offer to take a lump sum to close out your loan. This is called a settlement offer. This may be the best possible outcome for a homeowner who wants to keep his house, but can’t afford the second line payments. No matter what happens, though, your credit score will take a huge hit, and it may be some time before you can get any type of mortgage again.
Home Equity Loan Fraud
Leading up to the mortgage crisis, home equity loan fraud was rampant. Some fraudulent lenders were charging excessive fees at closing. Others were offering multiple refinances to the same borrower. Still others would ask you to sign over your deed to them if you were struggling to make payments, and then evict you from your home once you did. Thanks to aggressive government crackdowns, these schemes are no longer active.
The Federal Housing Administration (FHA) has enacted several rules and regulations that make the homeowner less vulnerable to home equity loan fraud. They now require that the borrower must receive specific information on interest rates and fees. As a result, it’s less likely that a lender can take advantage of an uneducated borrower. The FHA also has a list of fees that the lender may not charge a borrower. If your lender tries to tack these on to the loan, you can file a complaint directly with the FHA.
Unfortunately, identity fraud thieves have discovered a whole slew of possible targets in the home equity loan arena. If a criminal is able to get his hands on vital personal information, like your Social Security number, birth date, and/or passwords to your bank accounts, he can do severe damage. Once a thief has this information, he can set up telephonic banking privileges on your account, then transfer money from your HELOC into his own personal bank account. Once that happens, the criminal – and the money – disappears forever.
Most people will never encounter home equity loan fraud, but if you choose to tap your equity with a HEL or a HELOC, it’s better to be safe than sorry.
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Get Smart: Intelligent Ways to Use a Home Equity Loan
In the 1965 television series Get Smart, Agent 86, Maxwell Smart, did everything to not live up to his name. Luckily, he had the brilliant and beautiful Agent 99 to help him overcome all obstacles and ultimately finish as a winner. As Max would say, "If you don't mind, 99," we'd like to step in and offer some smart advice on home equity loans that you can believe.
Know Your Budget
Home equity loans are highly structured. You apply for a specific amount, you receive the money all at once, and then you repay in fixed monthly increments. This structure is ideal for funding a planned expense like a home remodel or new car purchase. If you can't budget the expense accurately, a home equity line of credit (HELOC) might be more appropriate.
Leverage the Tax Advantages
Borrowing from your home's equity may give you access to certain tax breaks that you don't receive from being indebted to credit cards or auto loans. Everyone's situation is different, however. That's why it's best to talk with your financial advisor to understand how the additional mortgage interest will affect your tax liability.
Set a Little Aside
Home equity loans have many potential uses. In addition to acting as a home improvement loan, they can be a lifesaver when tackling unforeseen expenses. If possible, avoid tapping all your equity to ensure that there's additional funding if an emergency arises.
Be a Savvy Shopper
Before you select a lender, research current home equity loan rates and shop around to get the best deal possible. If you have good credit, you should be able to obtain an equity loan with no closing costs. Be on the look-out for application fees, appraisal fees and broker fees in particular; you don't want those added to your loan balance. A recording fee might be unavoidable, but this money goes to the local government's recording office, not the lender.
Agent 86 might say that it's the old "use-your-home-equity-intelligently-to-enhance-your-life" trick. He should know. After all, his last name is smart.
Home Equity Loans: Steps for Success
Since all home equity loans are not created equal, you might find it frustrating when you consider your options. Make your life easier by taking a logical, organized approached to equity loan shopping.
In Alfred Hitchcock's movie, The 39 Steps, a man is caught in a web of intrigue that complicates his life and causes it to spin out of control. To avoid being caught in a similar circumstance when shopping for your home equity loan, here are five steps that will keep things simple and easy:
1. Shop around for the best deal. Start with your existing bank or credit union. You may also consider gathering bids online or responding to advertisements. Just remember to be skeptical about promises that sound too good to be true.
2. Know the product. Home improvement loans come in two flavors: the home equity loan or the home equity line of credit (HELOC). Know the basics of each so that you can assess which one is right for you.
3. Ask questions. Obtain a firm understanding of the points, APR, and closing costs associated with the loans you're considering. These items are detailed on the Good Faith Estimate, a document that the lender must provide within three days of receiving your loan application. One point to note when comparing your options: The APR for a home equity loan includes closing costs, while the APR for a HELOC does not.
4. Choose a rate structure. Home equity loan rates can either be adjustable or fixed. The interest on adjustable loans can fluctuate, exposing you to the risk of increasing costs. Fixed-rate loans have less risk, but can sometimes cost more for homeowners who end up selling in a few years. If you're uncertain how long you'll keep the property, consider asking your lender about a hybrid adjustable loan with a fixed introductory rate.
5. Know your closing costs. The Good Faith Estimate includes a quote on closing costs. Unfortunately, the actual costs at closing are often different from those on the estimate. Most of the fees are assessed by third parties, and therefore not under your lender's control. Ask your lender how closing cost changes are handled.
Equity loan shopping shouldn't be shrouded in suspense. Follow the steps and make your way to equity financing success.
Don't Get Trapped by Home Equity Loan PitfallsHave you ever noticed how people "in the know" also happen to be "in the dough?" The wealthiest people often make smart investment decisions based on informed opinions. You can do the same when it comes to debt, especially with home equity loans.
Even if you've never hacked your way through a jungle, you can imagine there are plenty of pitfalls. Poisonous snakes, annoying insects, and dangerous species-these are all perils you face when you veer off the beaten path. Tapping your home equity is no different. With a home equity loan, there are as many pitfalls as there are animals in the jungle. However, armed with a few essential facts, you can find a home equity loan that will do more help than harm.
Home equity loans and HELOCs: Two different animals
Even though home equity loans and home equity lines of credit (HELOCs) are both second liens on your home, there are significant differences between them. A home equity loan has a fixed rate, fixed loan amount, and fixed repayment schedule. In contrast, a HELOC works like a credit card. It offers a variable interest rate, and you only tap equity when you need it.
The wild over-spender
If you tend to overspend, borrow only the amount that you truly need. Banks are more than happy to lend you more and more money. Tap too much, and you may wind up spending thousands of dollars in long-term interest.
Avoid first lender quicksand
Don't go with the first lender you find. There are hundreds of home equity lenders-compare their rates and closing costs. Negotiate your deal and take your time. Remember, you're the buyer. If a lender knows you're shopping around, he may sweeten the deal.
Don't let costs sneak up on you
A common tactic among unscrupulous lenders is to sneak hidden costs onto a loan, and surprise the borrower with increased expenses at the closing. Avoid this high-pressure tactic by scrutinizing costs before the closing. They'll be detailed in a Good Faith Estimate, which your lender is required to provide. While it's true that the initial statement is just an estimate, final costs should be within a reasonable neighborhood from the original estimate.
A home equity loan can help you hack your way out of a jungle of heavy debt. Be mindful of the above tips, and you can avoid the most common home equity loan pitfalls.
Bad Credit Home Equity Loans
Lenders aren't generally considered Santa Claus; but if you have bad credit, finding a mortgage can seem like a gift from the North Pole. In today's market, however, loans for people with bad credit are available, even though their rates tend to be higher than conventional loans. Despite the elevated costs, you can still find a good home equity loan if you follow the tips below:
Four tips for home equity loans
- Shop around. Competition is a good thing for the consumer, and when it comes to home equity loans, there's plenty to choose from. And with more competition comes cheaper prices. Research lenders on the Internet and get quotes on rates and closing costs. Before making a commitment, check with the Better Business Bureau to make sure a lender doesn't have any complaints lodged against it.
- Understand the loan. The market is loaded with lenders who will try to pull a fast one on a person with poor credit and a lack of knowledge of the mortgage marketplace. Make sure that this isn't an impulse purchase. It's important to understand the specifics of your mortgage, and how loans differ. For example, an adjustable-rate mortgage will give you a low monthly rate for an initial period of three to seven years; but then the rate adjusts upward. On the other hand, a balloon mortgage will have the same initial, low payment period; but when it concludes, the entire mortgage will be due in full.
- Scrutinize closing costs. Each mortgage lender is required, by law, to provide you with a Good Faith Estimate detailing these costs. Make sure that you understand all the charges, and keep a watchful eye out for bloated origination fees.
- Get a loan you can afford. Most lenders will be happy to give you as much money as you want. They don't mind if you have to start making enormous monthly payments on the loan. Make sure the loan benefits you in the long run. Will it help you get your finances back in shape, and eventually qualify you for a better loan? That should be the ultimate goal of any financial transaction.
When it comes to home equity loans for people with poor credit, there is a Santa Claus. But if this is your situation, the biggest gift you can give yourself is to be a smart shopper and follow the tips above. In the end, you'll get a loan that will help, not hurt, your financial situation. That may become the best Christmas present you get this year.
Risks of Home Equity Loans
A home equity loan can be a hero if you're short of cash. It can also seduce you into thinking that you have financial freedom that you don't. Lulled by low payments and quick cash, many home equity loan users find themselves confronted by such troubles as balloon payments, penalties, and sky-high rates.
Four home equity loan traps
- Not paying it back on time: If you get into trouble by borrowing from a friend or family member, you risk losing a valuable relationship. If you borrow from a bank or credit card company, you might damage your credit rating or need to declare bankruptcy. If you default on your home equity loan, you may lose your home.
- Prepayment penalties spoil the party: Home equity loans often offer low closing costs and cheap initial interest rates. But if your loan includes prepayment penalties, you might be punished for paying off your debts in a quick and responsible fashion. For instance, if you decide to pay off your loan before the introductory interest rate adjusts higher, your lender might impose a hefty fee.
- Living it up in the present, forgetting to plan for the future: Some say that the "present" is a "gift" to be unwrapped in every moment of your life. And there's plenty of wisdom in that sentiment. But it's important to remember that if you ever find yourself in a hole, you must stop digging. With some lines of credit, for instance, the borrower is able to defer payment of principal. But eventually, you have to pay the piper. If you borrow money from your own line of credit just to pay the interest you owe on it, you could wind up with a balloon payment the size of your house within a few years. And with no money to pay it off, your lender may take that house.
- Lenders who are too easy can make your life too hard: If your lender encourages you to borrow 120 percent more than the value of your home, you might think that you just hit the jackpot. But before you sign on the dotted line, think this through carefully. It's often dangerous to borrow more than you can reasonably afford to repay. If you borrow more than your house is worth in order to pay off those nagging credit card bills, it won't make your problems go away, and may even make them worse.
Home equity loan: A true friend
When used responsibly, home equity loans are among the best financial tools on the market. If you avoid the dangers listed above, and repay the loan responsibly and with regularity, it can become your new financial friend, not an unexpected enemy.
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