6 Questions to Ask When Choosing a Home Equity Loan
What is a home equity loan?
A home equity loan (or, alternatively, a second mortgage) is a type of debt secured by the borrower's house that they can use for any purpose. There are two main types: A first-time borrower will typically be instructed to take out an unsecured or secured loan for purposes other than refinancing. But if you're refinancing your property, then you'll need a home equity refinance loan.
The main difference is that a home equity loan is disbursed all at once, while a home equity line of credit is not. Both loans will have fixed interest rates and fixed monthly payments; the only difference is how the payments are structured.
Your credit score will determine which type of loan you qualify for, so be sure to ask your lender which they recommend. If you have excellent credit, then a home equity line of credit may be your best bet.
But if you have poor or mediocre credit, then a home equity loan may be your only option—and an unsecured one might not even be available to you.
In either case, always check your options before taking out a home equity loan or line of credit.
What is home equity?
A home's equity is determined by subtracting the total amount of all mortgages against it from the current market value of the property. In a nutshell, it's how much money you would make if you sold your house.
The approximate value for a given property can be obtained from online calculators like this one. However, a more accurate figure can be found by using an appraiser (see below).
Homeowners are always free to borrow against their home equity—and because lenders are willing to lend up to 80% (or more) of your home's equity, it can be a convenient way to get a loan with little or no collateral required on your part. But if you can't pay it back, the lender will have the right to seize your house… so you'll want to be careful!
What is a home equity loan vs. a line of credit?
As we've said, there are two different types of loans that can be secured against your home's equity. Both will usually require you to own a primary residence, and both will require the property to have at least 80% equity for lenders to consider it.
The main difference between them is this: A home equity line of credit (or HELOC) is essentially a credit card secured by your property; when you borrow, you're given an amount of cash and charged interest on it every month with monthly payments.
A home equity loan, on the other hand, is a lump sum of cash that your lender will actually send to you. For this reason, an unsecured home equity loan might be required if you don't have sufficient property equity.
There's no question that both types of loans are attractive options for those with bad or mediocre credit. But it's important to understand the difference before getting one—it will affect different aspects of your financial life depending on which type of loan you take out.
Will a home equity loan or home equity line of credit hurt my credit score?
When you borrow against your home's equity, it counts as a debt immediately (even if the loan is secured). This negative impact on your FICO score is more serious than most people realize, and could be the deciding factor between a good or bad home equity loan deal.
In fact, because lenders typically grant up to 80% of your property's market value as collateral for their loans, some experts believe it could lower your credit rating by tens of points.
This is why you have to ask: If you can afford both monthly payments and principal amount (i.e. the total amount you're borrowing), then will the debt hurt your credit or not?
If it will, then you should proceed with caution. If you decide to go ahead and take out a home equity loan, make sure that you know how much money you're actually borrowing and the rate at which interest is charged—and check your credit for any negative impact on your score from taking out the loan.
What is an appraiser?
An appraiser (or valuator) is the person who determines a property's current market value. They work for either a real estate broker or as an independent consultant (but don't expect to get anything close to the full value of your home).
When you apply for a home equity loan or line of credit, the lender will want to know how much your house is worth and what amount they can lend against it without risking default. This is why you need an appraiser to determine the exact value of your property.
This kind of evaluation normally costs between $300 and $400—money that lenders usually allow borrowers to pay up front (along with any other appraisal-related fees).
How to ask your home equity lender for an appraisal
The first thing you'll need to do is identify the valuation company of a mortgage lender. Since most lenders have their own in-house appraisal services, you can usually ask them directly about the company they use.
You might also be able to find this information on the company's website, but don't expect them to be forthcoming about it. What you want is the name and contact information of an independent third party provider (these are often called "NAP" numbers—Network Access Point—and can often be found on a lender's website).
It's important to ask your lender this question before you take out any loan, so don't be afraid to ask!
Home equity loans and lines of credit are available for a variety of purposes including rehabbing the house, buying a new one and consolidating debts.
Paying off debt with one or more home equity products is not without its risks. If the money you're borrowing isn't enough to pay everything off, your lender may take legal action to obtain the rest. Such actions are more likely when there is little equity in the property and it is necessary for your creditors to pursue only a portion of what they claim is owing.
This usually results in the lender taking an assignment of the rest of the debt from your house. Subsequently, it will most likely sell your home or re-auction it to recover some or all of its money.
As a homeowner, you are not obligated to accept this sale. If you don't agree with the terms, there is nothing you can do to prevent it from happening—unless you decide to sue for false imprisonment (which probably won't be practical for most people).
The solution in such a case is usually to refinance the loan and take out another home equity loan (or line of credit).
Conclusion
A home equity loan or line of credit is the type of loan that allows you to take advantage of the equity in your property. It's a great way to pay off large debts quickly (without having to sell your home), consolidate debt, or even improve the house. However, there are several things to consider before taking out such a loan and knowing how much you can borrow helps prevent defaults and losses due to foreclosure.
Large home improvement projects done with a home equity loan won't necessarily improve the value of your property. That said, it will likely improve its cash flow, which can be extremely helpful in improving your overall financial situation.