You can use the equity in your home as collateral for a home equity loan. It’s a popular choice among homeowners who need to cover large expenses such as home renovations, medical bills, or college tuition. This guide will explain the fundamentals of home equity loans, how they work, and the benefits and drawbacks.
What are home equity loans?
To understand equity loans, you must first define what equity is. Your home equity is the amount left after deducting your mortgage debt from the current market value of your home. It is used as collateral for mortgages and loans secured by home equity. They are similar to second mortgages in that you are effectively using your home as collateral for another loan. These loans can be used for a variety of purposes, including debt repayment, education, home improvement, and other expenses.
Types of Home Equity Loans
- Fixed-rate equity home loans: If you have large bills that you need to pay off in full right away, a fixed-rate loan is perfect for you. The lender sends you the whole amount in one payment. You take out a loan against your home’s equity and make regular payments to the lender, including principal and interest. This type of equity loan, as the name implies, has a fixed interest rate for the term of the loan. The interest rates on fixed home equity loans are higher than those on conventional loans.
- Home Equity Line of Credit: Credit cards akin to revolving credit are offered by HELOC. A lump sum loan amount is not given to you in one payment. Instead, a credit line is provided to you, which you can use as needed. The equity in your home is used by the lender to calculate the loan amount and draw period, which can vary from five to twenty-five years. After that, you can withdraw a portion of the authorised loan amount as needed to cover various expenses during the draw period.
- Interest rates are variable, in contrast to fixed-rate home equity loans. HELOC rates are computed every day using the public index as a basis. Repayment is only expected to be made during the draw period for interest. You can begin making monthly payments to repay the entire amount after the draw period has ended. It is ideal for you if you require additional time to pay off your current debt and you require money for ongoing home improvement projects.
Comparison between Fixed-rate loans and HELOC
| Fixed-Rate Loan | Home Equity Line of Credit | |
| Interest Rate | Rates are fixed | HELOC rates are variable |
| Disbursement | Single lump sum payment | Revolving credit line |
| Repayment | Fixed monthly payments | Interest repayment during the draw period followed by full monthly payments |
| Lender Credit (discount points) | Lenders use discount points to lower interest rates | No discount points are used |
| Ideal Usage | When you have to make a big one-time payment | When you need funds for recurring expenses |
Calculation of Home Equity Loan Amount
Your equity will be Rs 10 lakh if you purchase the house for Rs 40 lakh and take out a home loan of Rs 30 lakh.
Rs 40,00,000 (market value) – Rs 30,00,000 (loan amount) = Rs 10,00,000
You can obtain a Rs. 10 lakh equity home loan.
Home equity is subject to fluctuations over time, meaning that its value may increase or decrease based on local real estate conditions. These variations are caused by several factors. Therefore, you need to hire a qualified real estate appraiser to calculate your home equity before applying for a loan.
Pros of Home Equity Loans
- Lower Interest Rates: In general, the interest rates on home equity loans are lower than those on unsecured loans such as credit cards or personal loans. For borrowers, this can mean big cost savings throughout the loan.
- Access to Large Amounts of Money: Borrowers can access large sums of money through home equity loans, which can be used to cover major expenses such as debt repayment, education, or home improvements.
- Fixed Monthly Payments: The fixed monthly payments associated with home equity loans facilitate budgeting and future expense planning for borrowers.
- Potential to Increase Home Value: Improving a property with a home equity loan can increase its value and potentially the borrower’s equity in the property.
- Faster Approval Process: A home equity loan may be approved more quickly than other loan types because the lender has a lien on the borrower’s property.
Eligibility criteria for Home Equity Loans
- Debt: Make sure your debt-to-income ratio is less than 43 percent.
- Income: You must present proof of income for the previous two years, at the very least.
- Equity: More than 20% of your home’s market value should be represented by your equity.
- Credit Score: As is the case with all loans, your credit score has an impact on your likelihood of being approved for one. Make sure that you have at least 620 credit score.
- LTV: The loan-to-value ratio shows you how much you still owe on your existing home loan. It should ideally be lower than 80%.
Process of Getting A Home Equity Loan
- Determine Your Eligibility: You need to have equity in your house to be eligible for a home equity loan. This implies that your mortgage balance must be less than the value of your house. To be eligible, you must also have a steady income and a good credit score.
- Gather Necessary Documents: To apply for a home equity loan, you will need to provide certain documentation, such as proof of income, proof of homeownership, and proof of insurance. As a result, make sure you have these documents ready before applying.
- Shop Around: For home equity loans, various lenders will provide varying interest rates and terms, so it’s important to shop around and compare offers from different lenders. Don’t forget to account for any fees or closing costs related to the loan.
- Choose a Lender: You can apply for the loan once you’ve located a lender that provides the best terms for you. In addition to running a credit check, the lender might ask for a home appraisal.
- Make Payments: Remember that a home equity loan is still a loan and that interest must be paid back on it. To avoid paying more interest, make sure you pay back the loan as soon as possible and make your payments on time. It’s critical to keep in mind that obtaining a home equity loan entails risking your house if you are unable to make the loan payments. Thus, before applying for a home equity loan, make sure you weigh all the advantages and disadvantages.
Conclusion
With the help of a home equity loan, homeowners can use the equity in their property to meet a variety of needs. But, since your house is the collateral, it’s critical to balance the advantages over the risks. To fully benefit from it, thorough planning and well-informed decision-making are necessary.