MORTGAGE KNOWLEDGE CENTER

PenFed Mortgage with Confidence

MORTGAGE

What Is a Home Equity Loan?

What you'll learn: Reasons to consider a home equity loan

EXPECTED READ TIME: 4 MINUTES

If you’ve lived in your home for a while then you may be thinking about home improvements, or maybe you need cash for an emergency, or you simply want to consolidate high-interest debt. In any of those cases, a home equity loan might be a great solution.

A home equity loan leverages the value you have in your home to provide you with the funds you need. This type of loan uses your home as collateral to provide an interest rate that is typically lower than what you’d find for other loan types.

How do I calculate my home’s equity?

The equity in your home is found by subtracting what you owe on your home from the current market value of your home. For example, assume the current market value of your home is $400,000 and you owe $200,000. Your equity is $400,000 - $200,000 = $200,000.

What are the advantages of a home equity loan?

Typically, home equity loans provide a lower interest rate that is fixed for the life of the loan, compared to different loan types like a personal loan. The reason is that you’re using your home as collateral.

With a home equity loan, you receive the loan funds all at once and begin payments immediately just like a regular mortgage. Since the interest rate is fixed, you’ll know what your payments are for the life of the loan and can budget accordingly.

Home equity loans can be used for things like:

  • Debt consolidation
  • Reducing your interest rates on high interest credit
  • Home improvements
  • Emergencies or emergency funds
  • Higher education

Is a home equity loan tax-deductible?

It’s possible that if you are within the borrowing limits and the funds are being used to either build, buy, or improve a home, a home equity loan may be tax-deductible. Be sure to consult with your tax advisor for any further information regarding the deductibility of interest and charges.

What are the disadvantages of a home equity loan?

While a home equity loan is a perfect solution for many financial needs, there are things you need to be aware of. If you plan to sell your home in the near future, the home equity loan needs to be paid off before or at the time of the sale. If you’ve used your equity loan funds to improve your home, you may find the return on investment (ROI) of your loan paid off.

Depending on your use of the funds, the loan may not be tax-deductible. You should always build a budget to determine if a home equity loan is a smart move and consult with your tax advisor for any further information regarding the deductibility of interest and charges. For example, if you are planning to use the funds to reduce high interest charges on credit cards, understand that this is still a loan. You are basically moving one type of debt to another form of debt, so you need to have the strength to avoid falling into old habits and growing your credit card debt again.

Since a home equity loan is using your home as collateral, should the housing market go south, you may fall into a situation where you owe more on your home than it’s worth.

Like a traditional mortgage, there are closing fees and costs involved with a home equity loan. Make sure you understand the total cost of the loan over time to determine if a home equity loan is the right move for you.

What is a HELOC and how is it different than a home equity loan?

A HELOC is a home equity line of credit. The two types of loans are similar because they both leverage the equity in your home and use it as collateral to provide an advantageous interest rate. The difference is that a HELOC is a line of credit that allows you to pull from the funds as needed while a home equity loan provides all of your loan funds up front.

Imagine you want to upgrade your kitchen and bath, so you hire a contractor to do all of the work. In this instance, getting a home equity loan might be a good choice because you will have access to all of the funds at once to pay the contractor and you have a fixed interest rate.

On the other hand, if you are a handy person and want to upgrade your appliances over several months, a HELOC might be a better choice because you don’t necessarily need the funds all at once. It makes no sense to pay interest fees on money you don’t need right now. With a HELOC, you can draw on the funds as you need them.

How do I get a home equity loan?

  1. Understand your credit. A strong credit report is always advantageous when talking about loans.
  2. Find out how much equity you have in your home.
  3. Find out your loan-to-value (LTV) ratio.
  4. Understand your debt-to-income (DTI) ratio. This your total debt compared to your income.

As with all financial decisions, it’s important to understand the reasons for considering a home equity loan and all of the pros and cons. Everyone’s financial situation is different; for many, a home equity loan is a great choice.

To learn more about HELOCs or home equity loans, contact PenFed: 

PenFed PenFed, Inc FREE - On Google Play