You thought getting a mortgage and buying your home would be the biggest financial decision of your life. Well, deciding whether to release equity from your home with a home equity loan can be just as big. Before making any decisions, it’s best to know everything about these types of loans.
Uncover the pros and cons of home equity loans right here!
Home equity – quick recap!
Home equity is how much money you have in your home. You can calculate the equity in your home by taking your remaining mortgage balance off the current value of the property. It’s essential that you use today’s value of your home rather than the sum of money you agreed to buy it for. This is because property valuations can increase and decrease for many reasons over time.
Let’s imagine your home has a current market value of £300,000 and you still need to pay off £200,000 through an existing mortgage. In that case, the property’s value minus the remaining mortgage payments equate to £100,000 equity in your home.
What is a home equity loan?
Home equity loans are a type of loan allowing you access to an amount of money based on your home equity with a fixed interest rate. They won’t offer to lend 100% of the equity you have because this is risky, especially if the value of your property decreases and you fail to repay. If approved, you can usually access up to 85% of the equity.
The loan uses the equity in the home as collateral, and you do risk losing your home if you do not repay the loan as agreed. The lender can make you sell the home – known as foreclosure – if you default on payments. The money raised from the sale would then be used to repay your first mortgage and the home equity loan. They’re likely to try and work with you on a solution to avoid this.
Most lenders offering home equity loans will only lend a minimum of £10,000. If you need less than this you’ll need to find the right home equity lender or consider a personal loan instead. However, home equity loans tend to have much lower interest rates than personal loans, unless you have an excellent credit score and can access the best personal loans.
What is a home equity line of credit (HELOC)?
A home equity line of credit (HELOC) is another way to take equity from your home. Standard equity loans and HELOCs use fixed and variable interest rates, and that’s partly because of the way they’re paid out.
While a home equity loan provides the homeowner with a lump sum, home equity lines of credit (HELOCs) enables the homeowner to draw their equity out in a similar way to a credit card. They access the money over a set period, known as the draw period which could last as long as three decades.
Is it bad to take equity out of your house?
Taking equity out of your home can be a good decision if you need to access a large amount of credit. You may need to use the money for an emergency expense or home renovation.
Home equity loans generally offer a lower interest rate than other ways of accessing a large amount of credit through a personal loan and credit card. You may even be able to use these loans to pay off your existing mortgage and save money.
However, they may not be a good idea for you and your specific circumstances. You should get professional advice from finance professionals or a mortgage broker before making a decision. And you should learn about the standard pros and cons of a home equity loan first
Can you lose your house with a home equity loan?
Home equity loans are secured against the equity in your home rather than the house itself. This is because any existing mortgage is already secured against the property. If you do not repay the loan as agreed with the lender, they can try to recover the debt by making you sell your home and then taking some of the money raised. This is called foreclosure.
If this were to happen, the mortgage lender and the equity loan provider would both be due money from the house sale, so you can pay off both. Any remaining money would be yours to keep.
If you are struggling to make mortgage payments or equity loan repayments, it’s best to speak with the lender early. They can often help you overcome difficult periods by reducing the monthly payments and extending the repayment period. Making you sell your home is in no party’s best interest.
Pros and cons of home equity loans
Understanding the extent of the pros and cons of equity loans is a prerequisite to deciding if you should use one. Below we have listed the major benefits and disadvantages of using one of these loans.
Advantages of home equity loans
- Access a larger amount of credit
Such loans can help you to access credit on a much greater scale than using other types of personal finance. You may be able to access hundreds of thousands of pounds, whereas a personal loan will only give you around £30,000 maximum.
- Access lower interest rates (not guaranteed!)
Because your equity is secured against the debt, it allows the lender to offer a lower interest rate compared to unsecured credit options. You’ll typically be able to borrow for less when using these loans. And you can get a fixed rate so you’ll know what your payments will be in the future.
- Longer repayment terms
The repayment terms of these loans can be considerably longer, as long as three decades in some cases. This might be because you’ve borrowed more than you would with an unsecured personal loan, but they still tend to allow longer repayment periods for smaller loan amounts too.
- Used for multiple purposes
You are not restricted on using these loans for a specific purpose. You could access them to pay for education and medical expenses, help out a family member with cash, buy a new car or complete large-scale home renovations.
Choosing to update and upgrade your property can be a wise choice. It can increase the market value of your home and increase your home equity at the same time.
Disadvantages of home equity loans
- Greater risk
With the equity in your home used as collateral in these loans, there is a real risk of being forced to sell your home if you do not make monthly payments on time and in full.
Lenders have the right to make you sell if you cannot repay what was agreed, including all interest payments. Therefore, they are riskier than unsecured options.
- Decreasing home value
The risks are heightened by the possibility of your home becoming less valuable. The equity you have in the property can decrease through a number of factors outside your control, such as changes to your local area.
If you can’t pay off this debt and are forced to sell, and the property sells for less than it was worth when the loan was taken out, you could end up owing even more after the sale and go bankrupt.
- Additional expenses
If you decide to use an equity loan, you’ll need to do your due diligence before accepting. This means paying for professional consultations or even specialist mortgage broker services. There are also additional fees relating to the loan itself, known as a closing cost. We’ve explained more about this additional expense below.
How much is the closing cost on a home equity loan?
Another expense of a home equity loan is the closing cost. Most home equity loans include a closing cost at the end of the loan repayments. The average closing cost is between 2% and 5%, although it could be more with some lenders.
This means if you were to take out a loan balance of £50,000, you would have to pay closing costs between £1,000 to £2,500 on average. This is seen as another disadvantage of using a home equity loan instead of a personal loan which will not include such a fee.
How many years do you have to pay off a home equity loan?
The period of time you get to repay a home equity loan will be strongly determined by the loan amount and the lender. A home equity loan may need to be repaid anywhere between five and thirty years.
Home equity lines of credit are different because the homeowner does not receive a lump sum. Payments during the draw period can last as long as 20 years. Only after the line for credit has ended will the money need to be repaid, which could be over a further 10-20 years.
HELOC vs home equity loan: pros and cons
The benefit of choosing a home equity loan over HELOCs is that you can access a lump sum with fixed interest payments. With a fixed interest rate, you’ll always know the exact amount of debt you need to repay each month. The disadvantage in comparison is that accessing a large amount of cash in one hit makes you vulnerable to property value decreases in your area.
The other benefit of choosing a HELOC over an equity loan is that you will only make interest payments on the amount you draw. However, those payments are likely to increase in line with rising interest. Managing your draws also requires a high degree of discipline to avoid unnecessary debt.
Approval for either is based on your financial situation and credit score.
Alternatives to a home equity loan
Even though a home equity loan can be an advantageous way to access large credit, some homeowners are reluctant to use them. One of the common reasons for avoiding these loans is that they’re based on the home’s value which could change and because it puts the property at risk.
If that sounds familiar, here are some alternative options:
- Personal loans – a personal loan can be a good alternative if you don’t need to borrow more than £30,000 and you have a good credit score. You might be able to access a similar interest rate without the closing fee. A credit card is another option if you need to borrow even less cash.
- Debt consolidation loans – a debt consolidation loan is a good alternative if you were wanting to access equity to consolidate debts.
- Cash out refinance – cash out refinance is when you use a second mortgage for more than your remaining mortgage. Thus, enabling you to access home equity. This can be a good idea if you can now get a better mortgage deal compared to what was available when you got your initial mortgage.
- Reverse mortgage – if you are over 55 and own a home outright without wanting to leave it to anybody after you die, a reverse mortgage will allow you to access a large lump sum and only pay it back from your estate or if you sell up.
Should I get a home equity loan?
There’s no way for the internet to answer if you should get a home equity loan. The decisions should be based on personal circumstances alone and why you need the lump sum. It’s best to learn as much about these loans first, which you can do right here on MoneyNerd. And then choose to get professional advice before you borrow from your equity.
It could be a fantastic move, or there could be a more appropriate option out there!