By Kirk Haverkamp
February 24, 2014 7:30 AM
Home equity lending is making something of a comeback. After being nearly shut down with the collapse of housing prices during the Great Recession, lenders are once again opening up their wallets and allowing people to borrow against the value of their homes.
Newly originated home equity loans and lines of credit rose by nearly a third during the first nine months of 2013, compared to the same period 12 months earlier, according to industry publication Inside Mortgage Finance.
While still only a fraction of its pre-crash levels — total 2013 home equity lending is estimated at $60 billion, compared to a peak of $430 billion in 2006 — rising home values in recent years are putting more equity in borrowers’ hands, while a gradually stabilizing economy is giving lenders more confidence to lend.
So the fact that they’re making a comeback is one thing to know about home equity loans. If you’re thinking about pursuing one, here are four other things you’ll need to know.
1. You’ll Need Equity
Equity, of course, is the share of your home that you actually own, versus that which you still owe to the bank. So if your home is valued at $250,000 and you still owe $200,000 on your mortgage, you have $50,000 in equity, or 20%.
That’s more commonly described in terms of a loan-to-value ratio – that is, the remaining balance on your loan compared to the value of the property – which in this case would be 80% ($200,000 being 80% of $250,000).
Generally speaking, lenders are going to want you to have at least an 80% loan-to-value ratio remaining after the home equity loan. That means you’ll need to own more than 20% of your home before you can even qualify. So if you have a $250,000 home, you’d need at least 30% equity – a loan balance of no more than $175,000 – in order to qualify for a $25,000 home equity loan or line of credit.
2. One of Two Types
There are two main types of home equity loans. The first is the standard home equity loan, where you borrow a single lump sum. The second is a home equity line of credit, or HELOC, where the lender authorizes you to borrow smaller sums as needed, up to a certain fixed amount. The type you choose depends on why you need the money.
If you’re looking at a single, major expense – such as replacing the roof on your home – a standard home equity loan is usually the best way to go. You can get these as either a fixed- or adjustable-rate loan, to be repaid over a predetermined length of time, up to 30 years. You’ll need to pay closing costs, though they’re much less than you would see on a full mortgage.
If you need to access various amounts of money over time – such as if you’re doing a home improvement project over a few months, for example, or to support a small business you’re starting – a home equity line of credit may be more suitable to your needs.
With a HELOC, you’re given a predetermined limit you’re allowed to borrow against as you wish. You only pay interest on what you actually borrow and you don’t have to begin repaying the loan until a certain period of time, known as the draw (typically 10 years), has elapsed. There are usually no closing costs, though you may have to pay an annual fee. The interest rates are adjustable, meaning you don’t get the predictability offered by a fixed-rate standard home equity loan, though you can often convert a HELOC to a fixed rate once the draw period ends.
3. Think Big
There’s one thing about home equity loans – they’re not particularly useful for borrowing small amounts of money. Lenders typically don’t want to be bothered with making small loans – $10,000 is about the smallest you can get. Bank of America, for example, has a minimum of $25,000 on its home equity loans, while Wells Fargo won’t go below $20,000. Discover offers home equity loans in the range of $25,000 to $100,000.
If you don’t need quite that much, you can opt for a HELOC and only borrow what you need. Remember though, that you still may be charged an annual fee for the duration of the draw period.
Even if you plan to use only a fraction of your line of credit, say $5,000 out of a $20,000 HELOC, you’ll still need to have enough equity in your home to cover the full amount. So if the smallest home equity loan or line of credit your lender will allow is $20,000, you’ll need to have at least $20,000 in home equity over and above the 20% equity you’ll need left after taking out the loan.
4. It’s Still a Mortgage
It’s easy to forget sometimes, but a home equity loan or line of credit is a type of mortgage, just like the primary home loan you used to fund the purchase of your home. And as a mortgage, it offers certain advantages and disadvantages.
One of the advantages is that the interest you pay is usually tax-deductible for those who itemize deductions, the same as regular mortgage interest. Federal tax law allows you to deduct mortgage interest on up to $100,000 in home equity debt ($50,000 apiece for married persons filing separately). There are certain limitations though, so check with a tax adviser to determine your own eligibility.
Second, because it is a mortgage secured by your home, the rates tend to be lower than you’d pay on credit cards or other unsecured loans. They do tend to be somewhat higher than what you’d currently pay for a full mortgage, however.
On the downside, because the debt is secured by your home, your property is at risk if you fail to make the payments. You can be foreclosed on and lose your home if you’re delinquent on a home equity loan, the same as on your primary mortgage. The difference is that in a foreclosure, the primary mortgage lender is paid off first, and then the home equity lender is paid off out of whatever is left.
So you want to treat a home equity loan with the same seriousness you would a regular mortgage. That’s the most important thing of all to know.
[Editor's Note: If you're considering applying for a home equity loan or HELOC, it's important to make sure you get the best terms possible, which means making sure your credit is in good shape. You can check your credit scores for free using the Credit Report Card, a tool that updates two of your credit scores every month and shows your credit profile's strengths and weaknesses.]