Home Equity Loan: Unlocking your home equity

What is the definition of a home equity loan? A home equity loan is just what it sounds like – a loan that uses your home equity as collateral. When your home secures a loan, it affects you in two ways – you assume some risk because if you fail to make your payments, the lender can foreclose and take your home. But because home equity loans are less risky to lenders than unsecured loans (like personal loans or credit cards), they come with lower interest rates. 

This article covers the best uses for a home equity loan, home equity loan interest rates and closing costs, and how home equity loans compare to cash-out refinancing.

What Are the Best Uses for a Home Equity Loan?

Home equity loans offer flexibility – you can use them for almost anything. However, home equity is a valuable asset, so you should treat it with respect and borrow carefully. If you're getting a large lump sum from a home equity loan, some of the best uses for the money include suitable investments, long-term purchases, and debt consolidation. 

What's meant by a good investment? Generally, they are low-risk opportunities that deliver a rate of return or financial benefit that outweighs your home equity loan costs. So, some ways you might invest home equity loan proceeds include:

• College expenses for yourself or your child
• Starting a business that has a high likelihood of being profitable
• Home improvements that add value to your home

A college degree can yield a solid return if it helps you earn more. Starting a business with home equity loan funds could help you increase or even replace your current income. And making home improvements can increase your gain if you decide to sell the property later. In the meantime, you may be able to claim a tax deduction for the interest paid on your home equity loan.

If your home equity loan helps you save or earn more than it costs, it’s probably a good investment. That includes large purchases or debt consolidation. 

Say you have $20,000 in credit card debt spread across five cards. The average APR is 16.99%. You check home equity loan interest rates and see they're hovering around 5%. Taking out a home equity loan to consolidate those cards could save you a lot of interest.

This assumes that you pay off the balance as quickly as possible and do not extend the repayment. Because even if you drop your rate from 16% to 5%, you might not save money if you take 20 years to pay off the loan. In addition, you won’t save if you continue to charge on your cards without paying them in full every month. Running up balances again will leave you worse off than before.

What Are Less-Great Uses for Home Equity Loans?

Home equity is an asset. It represents the difference between what you owe on your home and what it's worth. Accumulating equity in your home is generally considered one of the keys to building wealth, so it's not something that should be thrown away or wasted. 

So what kind of things would you not want to buy with a home equity loan? Generally, the list includes things that don't offer any tangible financial value. For example:

• Expensive vacations
• A wedding
• Shopping trips

It’s not that these things are not necessary – you just might want to purchase them with shorter-term financing. Unless you want to be paying for your wedding when your first child heads off to college. Here are alternatives:

• Take a 12-month personal loan to nail down wedding venues a year ahead and have it paid by the time you marry, or use whatever monetary gifts you receive to repay the loan. 
• A personal loan can also help you get great discounts on travel (50% is typical if you book your cruise a year in advance). Again, try to pay off the loan before you travel.

You might be wondering if it makes sense to use a home equity loan to purchase items of value, like cars or boats. Most personal finance specialists recommend matching your financing term to the life of whatever you buy. So you’d take a five-year loan for a car that you’ll have for five years.  If you borrow with home equity for that car, calculate a payment that will clear your balance in five years and stick to it.

What about using home equity to buy a vacation or a rental property? Again, it depends. Leveraging home equity to buy an investment property, for example, could pay off for years to come if that property continually generates rental income. A vacation home could also produce some revenue if you're renting it out for part of the year. 

When considering whether to use home equity in these kinds of scenarios, it's important to look at what you'll pay in interest and for closing costs. If the loan costs are reasonable and affordable and you can repay the balance quickly, home equity financing can be the best borrowing option for many purposes.  

Home Equity Loan Terms

Home equity loans typically have shorter lives than personal loans or auto financing. Typical terms run from 5-years to as long as 30 years. Your choice of term matters because it impacts the interest rate the lender charges and the total amount of interest you pay. 

How Much Can You Borrow With a Home Equity Loan?

It's also important to consider how much you can borrow with a home equity loan. Many lenders limit you to borrowing no more than 80% of your home's equity, although some go as high as 90% for well-qualified applicants. 

You calculate your maximum loan amount like this:

Estimate your current home value and multiply it by your lender’s maximum loan-to-value (LTV). If the lender allows LTVs up to 85%, and your property value is $400,000 you’ll multiply $400,000 by .85, getting $340,000. Next, subtract your current mortgage balance. If you owe $290,000, $340,000 - $290,000 = $50,000. That’s your maximum loan with that lender, assuming that you qualify.

Home Equity Loan Interest Rates

When comparing home equity loan interest rates to purchase loan rates, you might notice something obvious: Home equity loan rates are higher. 

There's a simple explanation for this. Home equity loans present a greater risk to the lender. 

If you already have a mortgage on the property, you're financially obligated to repay it. Adding a second mortgage in the form of a home equity loan can put more pressure on your budget. If you default, your first mortgage takes priority for repayment over the second. This means lenders bear a greater risk when granting home equity loans, which translates to higher rates. 

So how does a lender determine your home equity loan rate? It's based on several factors, including:

• Credit scores and credit history
• Debt-to-income (DTI) ratio
• Loan-to-value

Lower credit scores go hand-in-hand with increased foreclosure and bankruptcy rates, so lenders charge higher interest rates to compensate for the added risk. Higher debt-to-income ratios add risk because the more income you spend on debt, the less there is to repay a home equity loan. Finally, the higher your LTV, the greater the chance that your home equity lender won’t be fully repaid if if has to foreclose. 

Home Equity Loan Closing Costs

Home equity loans can carry closing costs, just like a purchase mortgage. These are costs you pay when signing off on the final paperwork for the loan. Depending on the lender, you might pay anywhere from 2% to 5% of the loan amount in closing costs. 

The list of typical home equity loan closing costs includes:

• Appraisal fees
• Credit report fees
• Attorneys' fees
• Document preparation fees
• Title search
• Notary fees

You may also pay an origination fee, which the lender charges for granting the loan. This may be a flat fee or a percentage of the loan amount. 

However, it doesn’t matter what they call the fees or what each charge is. It’s the total that matters. When comparing loans with different rates and costs, look at the loan annual percentage rate, or APR. APR can tell you which loan is more expensive over its lifetime. Note that APR only works if you compare loans with the same term (years). 

You might see lenders offering no closing cost home equity loans but use caution. Rather than charging closing costs upfront, the costs are rolled into the loan, meaning you pay them back over time with interest. For that reason, it's vital to read loan terms carefully to understand what you agree to. 

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Home Equity Loan vs. Cash-Out Refinance: What’s Better?

A home equity loan is one way to tap into your home's equity; a cash-out refinance is another. With cash-out refinancing, you're not taking out a second mortgage. Instead, you're refinancing your existing mortgage into a new loan and withdrawing your equity in a cash lump sum. 

Choosing a cash-out refinance could make sense if you want to pull cash out of your home and get a better deal on your current mortgage rate or terms. You'd still have just one mortgage payment to make each month rather than the two you'd have with a home equity loan. 

On the other hand, consider what you plan to use the cash for and what interest rate you might pay. Lenders charge more for cash-out refinancing, and they apply the extra fees to the entire loan, not just the cash-out. If you have a large mortgage and only want a little cash, cash-out refinancing is probably too expensive an option. For instance, if your refinance is $400,000, you want $20,000 in cash out, and the cash-out fee is 2%, it would cost you $8,400 in fees to borrow $20,000. That’s 42% of the amount you’re borrowing!

When tapping home equity, follow three principles:

• Make sure you’re borrowing for the right reason
• Match your term to the life of your purchase
• Shop with several lenders for the lowest cost financing.

Finally, understand that home equity is the main way many Americans acquire wealth. Respect it and borrow carefully.