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Ship lap, open concept, and a dream kitchen – if you’re a fan of HGTV, you likely consider yourself an expert in all things home decor. It can be fun to watch and plan for your own dream home, but have you ever thought to yourself (as you start yet another episode of Fixer Upper) - “How can they afford to do all of this?”
If you’re the typical homeowner, odds are you don’t have the extra funds on hand to do a home renovation, as even the “minor” projects can cost thousands of dollars from materials to contractors and everything in between. Although they may not always talk about the financial side of a home renovation on TV, homeowners everywhere are taking out home equity loans to help make their dreams a reality.
A house provides us many things - a place to raise our family, make memories, and call home. But what may not be the first thing to come to mind is that a home also provides us with a tremendous resource to tap into for funds when you need them for many purposes.
Together, we will become experts on the financial side of a home makeover with 5 important things to know about home equity loans.
You must have the equity in your home.
Although your name may be on the deed, you don’t actually “own” your home. The ownership resides with your mortgage lender in the form of a lien; this is why accessing your equity requires a loan. A home equity loan uses your home’s equity as collateral and allows you to borrow against it – serving as an assurance to your lender that you will repay the loan.
Before you go to apply for a loan, determine if your home has the equity you need. Equity is the share of your home that you actually own, versus what you still owe on your mortgage. For example - if your home is valued at $250,000 and you still owe $200,000 on your mortgage, you have $50,000 in equity.
When determining if you qualify for a home equity loan, lenders will look at your loan-to-value (LTV) ratio, meaning the amount of your first loan (mortgage) and the new loan (home equity) divided by the value of your home. Many financials, including Firefly, will lend to homeowners with a LTV as high as 90% and take other factors into consideration including your credit history and your income.
From a lender’s perspective, there is some risk to lending against an individual’s home (think back to the 2008 housing market crash
) which is why most financial institutions carefully evaluate. It’s really a safeguard for you and your lender in case of financial hardship or big market shifts.
For new homeowners, building equity is not always easy, as so much of your monthly payments go to paying interest at the beginning of the loan term. Although building equity in your home can take some time, years down the road it will become a great investment for you and your future. This is why some buyers may look for homes with lower purchase prices that have the potential to return great market value when updated or fixed up. The greater opportunity for equity, the more you could realize when you sell down the road.
Loan vs. Line
Everyone likes options, right? When considering an additional home loan from equity, you have a choice between two options - a fixed home equity loan and a home equity line of credit (HELOC). So, how do you know which one is right for you? Let’s dive into each option a little deeper.
A fixed-rate home equity loan is a loan for a specific lump sum and has a specific timeline for repayment.
Since this type of loan has a fixed interest rate, your loan payment will stay the same each month allowing you to more easily set a budget month after month. You’ll also get all the funds you need for that kitchen remodel right away. Keep in mind, as the housing market continues to fluctuate, it may be risky to tap into all of the available equity in your home if property values in your neighborhood decline. In fact, many lenders require you to keep at least 20% equity in your home, as a cushion in case home prices fall. Since home equity loans are offered on the basis of using the equity in your home as collateral, it is important that lenders are confident that the amount they lend out will be returned – because as housing prices fall, so does equity. From a homeowner’s perspective, not having the ability to tap into all of your home’s equity is actually a good thing. If home prices fall, you could be left in a negative equity position, paying more on your mortgage than what your house is even worth.
A HELOC, on the other hand, is a revolving line of credit that allows you to make smaller withdrawals from available equity as you like, up to a pre-determined amount. It works more like a credit card in that you have a maximum amount of money available to borrow and pay back - taking what you need, when you need it. Some benefits that come with this type of loan is that you are only paying interest on the amount that you draw at any given time, rather than on the total amounts available in your credit line.
Different from that of a home equity loan, HELOCs have an adjustable interest rate that can change and potentially increase - your monthly payments from time to time, making budgeting in advance harder to do. Plus, with funds readily available, it may be tempting to tap into all of your home’s equity at one point, but you may find yourself burdened with large principal and interest payments, with a much longer repayment period.
The right lender should offer both options and talk about what may be a better fit for your needs and financial situation.
Can home equity loans only be used as funds for home improvements?
Although it is in the name, home equity loans can be used for any large expense not just those related to your home. Considered a second mortgage because it essentially adds to what you owe on your home, a home equity loan is commonly used for home renovations because projects like a kitchen remodel or new siding typically require a larger chunk of change to complete and doing so could increase the sale price of your home in the future. Other common uses for a home equity loan are:
- paying for college tuition
- a dream family vacation
- consolidating other, higher-rate debt
With significant equity available, these are excellent options to support paying down other debt to free up additional cash for smaller home projects or needs.
What else is there to consider when borrowing against the equity in my home?
Although qualifying for a home equity loan has become slightly easier since the housing market crash of the mid-2000s, it doesn’t mean financial institutions are handing out equity loans to everyone. You’ll still need to demonstrate you are reliable borrower with appropriate credit history and income to pay off the loan. Another thing to consider when taking out a home equity loan is the potential tax deductibility benefits under the new tax law
. Deducting your loan interest could save you thousands of dollars, but only if used to improve and add more value to the home that secures the loan. If you're going into debt to make changes to your house, take steps to ensure the changes you’re making will add enough value to cover their costs. A great resource to help make sure you’re on the right track is to consult with a realtor and get a better sense of what changes to the home will provide the most value down the road.
If you decide to use your home equity loan for a home improvement project, there are additional costs to keep in consideration including closing costs, an appraisal, permits and contractor fees, if needed. Also, what if the project becomes bigger than your loan? Do you have additional funds to finish your kitchen remodel? Depending on what you plan to do with your equity, have a backup plan to support your goals if needed.
With all things considered – if you think you’re ready to apply for a loan and are excited to make updates to your home or use the funds for a family vacation, it is important to know that obtaining a home equity loan is not instantaneous. Because of the evaluation involved, you can’t call on a Friday and expect to have the loan the following Monday. The process, from start to finish, can take time so be sure to plan ahead!
Crunch the numbers.
One of the greatest benefits of being a homeowner is the ability to build equity in your home, which is a very valuable asset. Before taking the leap and applying for a home equity loan, use Firefly’s Simple Loan Calculator
to get a better idea of your potential monthly payments and determine if now is the right time financially, to take on an additional home loan.
By doing the research and planning ahead, you are already taking the right steps to becoming an expert on home equity. If you find you have more questions along your journey, ask Firefly for more resources, advice and information – we’d be happy to help see you through the process.