Also known as a second mortgage, a home equity loan permits you to borrow money using the equity you’ve built up in your home as collateral. Home equity lending has changed a lot in the past few decades.
In the late 1990s, home equity loans exploded in popularity as a fairly simple way for consumers to circumnavigate tax charges, which changed in 1996 to eliminate deductions for interest on the majority of consumer purchases.
But throughout the decade that followed, the home equity loan frenzy eventually led to dangerous borrowing. In 2006, combined home equity loans reached a peak of approximately $430 billion—only to plummet in the years that followed. After housing prices nearly collapsed during the Great Recession, home equity lending reached an all-time low.
Today, lenders are once again willing to open up their wallets to allow people to borrow against the value of their homes. In addition, housing prices are on the upswing, which means that borrowers have access to more equity. And as the economy stabilizes, lenders are more comfortable offering home equity loans.
Are you considering applying for a home equity loan? Here’s what you need to know.
You’ll need equity.
Equity refers to the share of your home that you actually own, compared to the money that you still owe the bank on your mortgage. For example, if you home is worth $300,000 and you still owe $200,000 on your mortgage, you have $100,000 or 33 percent in equity.
These figures are often described as loan-to-value ratios. In other words, the pending balance on your loan is compared to the value of the property. For the example above, the loan-to-value ratio is 67 percent. The lower your loan-to-value ratio, the more willing lenders will be to lend you money.
Generally, lenders will require at least an 80 percent loan-to-value ratio remaining after your home equity loan. That means that you will need to own more than 20 percent of your property before you qualify for a loan.
Be careful how you use a home equity loan.
Responsible borrowers will find that home equity loans are useful tools. They provide a steady and reliable source of income, but like all loans, they have to be repaid. Fortunately, a low interest rate and the tax deductible interest payments make home equity loans a smart financial choice.
It’s important to keep in mind, however, that when you take out a home equity loan you could lose your home if you fail to make your loan payments. Consider home equity loans for upgrades that will improve the value of your home, and investments that will improve your quality of life and/or increase your earnings. Home equity loans can seem like an easy solution for borrowers who have fallen into a vicious cycle of spending, borrowing, spending, and incurring increasing debts. You might want to reconsider if you’re applying for a loan that is worth more than the value of your home. These types of loans come with higher fees to make up for the lack of collateral.