What is a Home Equity Loan?

What is a Home Equity Loan?

If you are fortunate enough to have some equity in your home after going on a wild ride in the real estate market over the last eight years, cherish that equity and use it (or maintain it) wisely. 

If you need to borrow, a home equity loan remains one of the best alternatives for accessing funds at a low and largely controllable cost.  In most cases, the interest cost of borrowing against the value of your home is even tax deductible.  For the most part, if you have a financial need, using your home equity is the smartest way to meet that need.

The most common way to tap your home equity is via a Home Equity Line of Credit, often referred to as a HELOC.  Borrowers are often attracted to HELOC’s because the interest rate on a HELOC is almost always tied to the prime lending rate.  Lenders are attracted to HELOC’s for the same reason.  Lenders enjoy far greater flexibility with loan products for which interest rates fluctuate with market conditions.  A variable rate loan insulates lenders from experiencing unfavorable impacts on their yields and the spread between what they charge for the money they lend and their cost for access to that money.

As you are likely aware, we have been in what has been referred to as a “low rate environment” for about seven years.  The prime lending rate is still very low as compared to historic levels even with the recent .25% increase.  Most economists are predicting, however, that the prime rate will continue to rise for the forseeable future.  Many questions remain, though, regarding how fast and to what extent the rate will increase. 

As a borrower or potential borrower, this is information worth noting because if you borrow money on variable rate terms, such as you would through a HELOC, your monthly payment will increase as interest rates rise.

With this in mind, another alternative would be to obtain a Fixed Rate Home Equity loan.  They are less common than HELOC’s, but they can be equally as effective and provide you with many of the same benefits.  As the name implies, this loan utilizes a rate that is fixed for the life of the loan, which could be desirable for you in a rising rate environment.  With this type of loan, you gain the certainly of knowing exactly what your payment will be each month for the life of the loan, but you give up much of the flexibility associated with a HELOC.

With a HELOC, the term is usually 20 years, the first 10 of which constitute the draw period.  This means that you have the option of borrowing up to the established credit limit of the HELOC at any time during the first ten years of the life of the loan.  You are still obligated to make loan payments during the draw period, but the amount you owe is constantly re-amortized based on what you borrow and what you pay back during that time.  After that point, whatever you owe is then set and you will have an additional 10 years to pay off the loan, but you will not be able to borrow additional funds.

With a Fixed Rate Home Equity loan, you set the amount that you are going to borrow upfront.  There is no additional borrowing capacity and the length of the loan is much shorter, often five to seven years.  The shorter agreed upon term is what allows the lender to offer you a fixed rate that is sometimes lower than that of a HELOC.

To better understand which option would be best for you and your family, let’s first quickly define home equity.  You can determine the amount of equity you have in your home by subtracting the amount you owe on your home from the value of your home.  The amount you owe is determined by adding up the principal balance of your mortgage and any other loans that you have taken against your house.  Determining the value of your home is a little more subjective.  Ultimately, your home is worth exactly what the next buyer is willing to pay for it.  For a free estimate, however, ask a local realtor for a Competitive Market Analysis (CMA).

Once you have your equity number, you will next need to determine your loan to value (“LTV”) percentage in order to calculate how much you will be able to borrow.  Policies vary from lender to lender in terms of how high of an LTV each one will allow.  Your LTV percentage is determined by completing the calculation noted above and dividing the total amount of your loans into the total value of your home.  Generally speaking, most lenders will not allow you to go above 90% LTV.  Some will limit you to 80%.

If there is room for you to borrow once you have subtracted the amount you owe from the number that represents the total amount of LTV allowed, you have equity for the sake of this example.

Even with the risks and concerns related to borrowing in a rising rate environment, there are good reasons to tap your home equity and to obtain a HELOC.  For instance, if you have made or intend to make a long-term commitment to reside in your current home and you need to make improvements to your home, it absolutely makes sense to utilize the equity in your home for those improvements.  Perhaps the exact amount of the expenditure is unknown at the time you obtain the HELOC or you may just want the flexibility of knowing that you have additional borrowing capacity should you need it.

As is always the case, you should clearly understand all of your options, including a other types of loans or using cash reserves, but investment in your family home is almost always a sound choice and the money you spend improving your home will almost always be returned to you in the form of appreciation in the value of your home. 

If you have a heavy debt load that bears high interest rates, you may want to consider consolidating that debt via a Fixed Rate Home Equity loan, especially in cases where you are barely making the minimum monthly payments and/or the bulk of your payments are going toward the interest on the loans versus the reduction of the principal amount owed.  Using this type of loan to reduce your interest rate and your monthly payments is a smart move as long as you are also committed to sound financial practices.  In other words, don’t bother consolidating your debt just to go back out and run up your credit card balances again, you will only compound your financial problems.

Although it is often not advisable to borrow money for the purpose of investing it elsewhere, there are opportunities that are worthy of careful consideration.  Many real estate investors get started by using the equity in one property to make a down payment on an additional property.  A HELOC will allow you some flexibility in your decision making and will also provide you with the option of borrowing to purchase one property, paying that down, and then possibly purchasing or investing in another property.  A Fixed Rate Home Equity loan will help you cap your exposure or limit you to your exact need should you be in the position of knowing the exact amount you would like to invest.

As would be the case for any venture you consider, it is vitally important that you understand all of the factors that can or will impact the benefits and risks associated with that venture.

There are also situations that are not conducive to using your home equity.  It is never advisable to payoff a lower interest rate debt with a higher interest rate debt or with debt that has the reasonable potential to be a higher interest rate debt.  This is especially true in a rising rate environment.  Do not trade a short-term gain for long-term pain.

It is vital to maintain a contingency plan in order to be prepared for unforeseen circumstances.  Tapping 100% of the equity of your home for virtually any reason is not reflective of sound contingency planning.  Furthermore, it is healthy and logical to maintain control of your finances.  Using all of your equity in what is often your most precious financial asset is not consistent with preserving that asset.  Do not put yourself in a position that would jeopardize your ownership or control of your home.

When considering whether or not to borrow against some of the equity in your home, be sure to spend the time needed to fully understand the terms under which you will be making this decision.  Understand the interest rate options and the variability of those options.  Understand the length of time you will have to repay the loan.

It is equally important for you to understand your objective in using your equity and what you are looking to achieve, whether it be an improved home or lower credit card debt.  Make sure that the use of your home equity is a worthwhile endeavor.

If you decide to use it, make your decision carefully and use it wisely.

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This article is part of Scott Arney's educational series, entitled The Serial Decision Maker.