Avoid Pitfalls When Getting Home Equity Loans
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What are the dangers of home equity loans? We discuss the benefits of using a home equity loan or HELOC and look at home equity loan problems to present a balanced view.
If you are considering using one of these options and want answers that cut through the noise – read on!
Home equity defined
Equity is the amount of an asset you own without any debt, therefore, home equity is the amount of your home you own outright. To calculate your home equity you must subtract the value of your existing mortgage from the current value of your home – not the price you paid for it. If you have any other debts secured against your property or home equity then these also need to be subtracted.
For example, if you have a home worth £250,000 and a remaining mortgage balance of £150,000 then your home equity will be £100,000. Equity is usually expressed as a percentage of an asset. In this example, the homeowner would have 40% equity in their property.
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What are home equity loans and HELOCs?
A home equity loan or home equity line of credit (HELOC) will allow you to borrow against your equity. Lenders will usually allow you to borrow up to 80% of your equity maximum, so if you have £100,000 equity you could use a home equity loan or HELOC to access up to £80,000 of credit.
But home equity loans and HELOCs are not exactly the same. The loans provide a lump sum that starts being repaid through a monthly payment straight away, plus a fixed rate of interest.
On the other hand, HELOCS provide a line of credit that can be accessed over a draw period of many months or years, similar to the way people access money using a credit card. The homeowner usually only pays interest on the money over the draw period and then both the capital and interest after the draw period with a variable interest rate.
Both options may offer lower interest rates than personal loans and credit card options, depending on your income, credit score and other factors. You might still be rejected for either of these credit options.
Can you borrow money at any time with a home equity loan?
A home equity loan gives you all of the money straight away in a lump sum, whereas the HELOC provides it in instalments dictated by the borrower. The money can only be taken out over the draw period and never after.
Some equity loans and HELOCs require a minimum loan amount to be used, around £10,000. This means you’ll need close to £12,000 in equity to be able to get any credit at all.
Why do people use home equity loans?
Borrowers choose an equity loan or HELOC for many reasons. One of the most prevalent is to complete home renovations, possibly even complete home projects from the basement to the roof. You may want to create an extension or convert your loft into a bedroom. Doing so could make the property more valuable and cleverly increase equity at the same time.
Another popular reason to take out these loans is to consolidate existing debt. Merging your debts together is possible by taking out new credit large enough to pay back what is owed to other lenders. It’s worthwhile if the new interest rate is lower than the interest currently being repaid. With equity loans having a low rate on average, they can be a great vehicle to make debt consolidation work.
The benefits of a home equity loan
The main benefits of using these loans or a HELOC are:
- Large credit
Taking out a home equity loan enables some homeowners to get large amounts of credit that would not be possible in other ways. Whereas personal loans are typically capped at around £25,000, an equity loan can help people get over £100,000 in some cases. This is helpful if you are using the money for home improvements or big-ticket purchases.
- Lower interest rates
By securing the home equity as collateral within the loan, lenders feel more assured that they will get their money back if you do not keep up with your monthly payments. Thus, they offer lower interest than alternative unsecured options.
Note; You may not be subject to high interest with unsecured options if you have a good credit score.
Is there an appraisal with a home equity loan?
The lender must accurately calculate your equity to offer a safe loan amount. Sometimes they may need the help of a professional estate agent to get an updated value of the property based on the current market. This is known as a property appraisal.
There may or may not be fees associated with this, which can make the loan or HELOC more expensive than it looks at first glance.
Is it bad to take equity out of your house?
Taking equity out of your home is sometimes seen as a very smart choice, and at others times, it is seen as a bad idea. Those in the first category view home equity as dead money not working for you and not being utilised effectively. Whereas those in the second group see using home equity as selling your home, brick by brick to be paid for again.
The truth is that it can neither be a good or bad idea in generic terms. It all comes down to your personal situation and why you want the cash.
Can you lose your house with a home equity loan?
The biggest pitfall when you take out a home equity loan is that you can lose your property if you fail to repay the cash. Because the equity is secured as collateral within the loan agreement, the lender has the right to make you sell your property and recover what they are owed in the event that you stop paying. This process is officially known as foreclosure.
Missing one payment is not likely to result in foreclosure. Lenders generally work with homeowners to come up with solutions during periods of financial difficulty. This could mean reducing monthly payments but extending the loan so you end up paying back more.
What is the downside of a home equity loan?
Losing your home is a real possibility if you take out a home equity loan irresponsibly. But the other downside of using these loans is the closing costs. A closing cost is a fee payable at the end of the loan term. You could be asked to pay between 2% and 5% of your total amount of borrowing.
For example, a loan of just £10,000 could cop you an additional £200 to £500 fee. Closing costs can wipe out any savings you would make through a lower interest rate. You need to know the extent of these fees when agreeing; they could make unsecured credit options more attractive.
Home equity loan risks summarised
The pitfalls of getting a home equity loan can be summarised as:
- Home at risk – this will only occur if you cannot pay back what is owed.
- Unforeseen cost – you may sign the credit agreement without fully understanding additional fees.
- Rising interest rates – this only applies to a HELOC where the rate is not fixed. It could make you have to pay back more than expected.
- Property devaluations – if your house declines in value you could end up with negative equity.
- Lower credit score – leveraging equity may cause your credit score to decrease
How to avoid the pitfalls of a home equity loan
You cannot avoid all of the risks associated with taking out an equity loan over the long run, but you can mitigate some of those risks.
The biggest pitfall to avoid is overborrowing and not being able to make repayments should your income level change. Unforeseen events can cause your income to drop, such as ill-health or injury, which you may not be considering. This could lead to defaults and even foreclosure.
By not borrowing more than what is needed you can mitigate this problem. You should also keep a monthly budget to monitor spending while repaying.
If you are worried that your property could become less valuable, then do not utilise all of the equity available. This is good guidance even if you are confident your property value will increase.
Another way to mitigate the risks of home equity loans is to avoid this method if you are using it to solve cash flow problems. Taking out more credit in difficult circumstances is extremely dangerous and it could easily backfire.
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