1. You Need Equity, of Course.
Equity is what share of your home you actually own. Paying towards the principle of your loan is how you build it. If your home is valued at $300,000 but you still owe the bank $240,000, you have $60,000 equity, or 20% share in your home. This is generally described as a loan-to-value ratio and compares the remaining balance on your loan to the value of the property. In this example, the loan-to-value ratio would be 80%.
Lenders prefer there be at least 80% loan-to-value ratio remaining after the home equity loan. In order to be a prime candidate for this type of loan, it’s best to have more than 20% equity.
2. There are two main equity loans to choose from.
The standard home equity loan is when you borrow one large sum of money, very similar to a primary mortgage. The second type of home equity loan is borrowing a line of credit, or HELOC, where you borrow small sums as needed up to a certain amount.
The standard type of home equity loan is good option when you have to spend the loan similarly. For instance, one big home repair like fixing the foundation, or replacing your septic system can both be large expenses. This type of loan has closing costs, but not as much as you would see on a full mortgage and has a predetermined pay off date.
If your planning on remodeling your home, a project that could potentially take months, a HELOC may be the best type of home equity loan. A HELOC is similar to a credit card, you only incur interest on what you actually borrow. There is not an ending period unless you payoff/close the line or sell your home. and you don’t have to start paying off the loan until a certain period of time is up. That period of time is called the draw. There aren’t any closing costs, but you may have to pay an annual fee.
3. Make it worth it.
Most of the time lenders don’t like giving small home equity loans. Some banks have a minimum for these types of loans and they’re often in the $20,000 range. If you don’t need all of that cash, you could opt for the line of credit loan and only borrow from it what you need. However, if you take out a HELOC for $25,000 and only need $10,000, you still need to have the equity to cover the full amount.
4. A home equity loan is a mortgage.
There are certain advantages and disadvantages of taking out a home equity loan or line of credit, just like the primary mortgage on your home. One advantage is that like a full mortgage, home equity interest is tax deductible. Check with your tax advisor to be certain of all the limitations. Another advantage to this type of loan is lower interest rates that most credit cards. However, they are usually higher than most primary loans. One disadvantage is that your debt is backed by the value of your home and any failure to make payments puts your property at risk. It’s important to treat your home equity loan with the same gravity as you would when purchasing a home for the first time.
If you’re not quite ready to make that move up to a bigger home, a home equity loan could be the tool you need to up the value of your current residence. Improving your home is the best way to get a return on your investment.