A home equity loan is a form of the second mortgage that allows homeowners to borrow against the value of their house. This can be helpful if you need extra cash for an emergency or want to renovate your home. However, there are several disadvantages too.
Before choosing a HEL, it's essential to understand the advantages and disadvantages. Here are some of the benefits and drawbacks of this type of loan:
Advantages
- A HEL provides an immediate source of cash so borrowers can consolidate credit card debt or pay for other expenses.
- With a HEL, there is no need to reapply (each time additional funds are needed)
- The minimum down payment required by some lenders for a new HEL is only 5-10%, with no additional closing costs.
- A HEL can be a low-cost loan if interest rates are low
- Borrowers need only one mortgage insurance premium instead of two for a primary and secondary property
- A HEL allows borrowers to take equity out of their homes without putting the house on the market
- The interest paid on HELs is tax-deductible
- For some homeowners, borrowing against home equity is an attractive alternative to taking out a loan on their credit cards.
- A home equity loan lets homeowners take cash out at relatively low-interest rates. They can then use this money plus their tax deductions to pay for expensive items and consolidate their debts. It is also a good option for people who owe too much on credit cards or other types of personal loans.
Disadvantages
- HELs typically accrue interest at variable rates, which means that payments can go up if interest rates increase.
- A home equity loan may involve more red tape than other types of loans, such as applying for the loan in person or having to get appraisals.
- Some lenders require borrowers to pay private mortgage insurance (PMI) with a second loan.
As with any type of home-secured loan, borrowers should know that paying off other debts may increase the risk associated with holding a HEL. If you stop making payments on your first mortgage because you are using the equity to pay for other things, your house could end up in foreclosure even if you continue to make timely payments on your HEL.
Compared to other types of loans, including credit cards, car loans, and personal loans, interest rates for home equity loans are higher because they act as last resort financing - something you turn to only when no one else will give you money. High-interest rates can make it more challenging to pay back your loan, and you could end up paying a lot.
You may not qualify for a new mortgage. If you have other homes or investment properties, you should consider selling those first before considering a home equity loan. The interest rate on these types of loans is usually higher than what you'd qualify for with the purchase of another home.
How Much Can You Borrow with a Second Mortgage?
Typically, lenders want borrowers to use their equity as collateral for a home equity loan. This means that the house has to have enough equity, which is determined by subtracting your current mortgage balance from your property's fair market value. If you take out a second mortgage for 100% of the property's value, then this is what lenders will use as a benchmark to determine how much they can lend you against it.
If a home equity loan is only 80% of the property's value, then this type of loan may provide enough funds for you to do renovations. However, if you want more money, home equity loans have disadvantages because there will not be enough equity in your house. This means that it can give lenders room to come after other assets should the borrower default on their payments.
For homeowners struggling with existing debts and difficulty making monthly payments, however, a second mortgage might be the only way they have available to get cash. In some cases, having 400% - or even 500% - of your original mortgage balance due at a single time may force you into bankruptcy. Even though there is a limit to how much lenders can loan you, you still must be careful about the amount they borrow against their homes because they can end up losing more than just what's owed on their mortgages if things don't go according to plan.
Takeaway
Staying current with your payments is key. This means that if you want to take out a home equity loan, then be sure to keep it as low as possible by finding one with favorable rates. Be sure to shop around for competitive quotes before settling on one lender. A lower interest rate can mean significant savings over time and a more manageable repayment schedule for you.
You should also try not to use your home equity line of credit or second mortgage as an emergency fund. If things go wrong, you could risk losing your home if there is not enough equity. However, if you use it for repairs or renovations, you can also ensure that your home is in good condition when it comes time to sell.
