How a Home Equity Loan Can Help (and Hurt) You

home equity loan

If you don’t have much money in the bank but own a home, you have access to a huge asset. Depending on how large of a down payment you made and how much your home’s value has increased, you could have thousands in home equity — the amount of money your home is worth relative to the amount you still owe. It’s enough to make anyone feel rich.

Many people take out a home equity loan to pay for home improvements, big purchases, or even pay down debt. With low interest rates, it can be an appealing option.

However, home equity loans can have serious consequences. This type of debt can sometimes be a gamble; fall behind on payments and you could lose your home.

What is a home equity loan?

A home equity loan (HEL) is a way to borrow money at a low interest rate to make a big purchase or pay off debt. In fact, fixed interest rates can be as low as 4.5% or 5%.

The reason the rate is so low is because the loan is a secured form of debt, meaning you have to provide collateral to borrow the money. With HELs, the collateral is your home.

Unsecured loans, such as personal loans, do not require you to have collateral. Without anything guaranteeing the loan, lenders set higher interest rates to offset their risk.

According to the Federal Trade Commision, the amount you can borrow through an HEL is typically limited to approximately 85 percent of your home’s equity. However, the loan amount and terms are dependent on other factors, too. Lenders will also review your credit report, income, and the current value of your home.

How does a home equity loan work?

Your home’s equity is the current appraised value of your home minus what you owe on it today. For example, if you own a $200,000 house and you owe $150,000 on it, your home equity is $50,000.

If you qualify for an HEL, you might be able to borrow up to 85 percent of the home’s equity. In the example above, you could borrow up to $42,500.

Most banks and credit unions offer HELs, and the loans come with a set repayment term and monthly payment. Some HELs have fixed interest rates — meaning the interest remains the same over the length of your loan — while others have variable interest rates. With a variable loan, the loan’s interest rate can go up over time.

Depending on your situation, you might qualify for a loan with a longer repayment term, allowing you to make smaller payments each month. You could even qualify for an HEL with a 30-year repayment term.

Benefits of home equity loans

HELs are so appealing because of their low interest rates. Compared to other forms of debt, HELs can be much more affordable.

Jeff McGrath, a branch manager with Crown Mortgage Company, said there are other perks, too.

“Under current tax laws — subject to change, obviously — the interest on home equity loans is, under most circumstances, tax deductible,” he said.

According to the IRS, federal tax law allows you to deduct the interest you paid on a home equity loan. However, the loan cannot exceed $100,000. The HEL tax deduction can be affected by other factors, such as your income bracket, so it’s a good idea to consult with a tax professional before submitting your tax return.

Smart ways to use a home equity loan

Although HELs have several benefits, taking out a loan in any form is a big decision. An HEL does have risks, so it shouldn’t be used for any big purchase. However, if used carefully, applying for an HEL can be a useful option in the following situations:

1. Debt consolidation

If you have credit card debt, an HEL can help you save money over time.

“[Low interest rates] make home equity loans a smart choice for debt consolidation,” said McGrath. “This is especially true when consolidating credit card debts with very high interest rates.”

The Federal Reserve reports that the average interest rate for credit cards is 13.08%. If you had a $20,000 credit card balance with the average interest rate and took 10 years to pay it off, you’d pay back $36,000 in total. That’s nearly double what you originally borrowed.

By contrast, if you took out an HEL with a 10-year term at 4.43% interest and used it to pay off your debt, you’d pay back just $24,840. You’d save over $11,000 by consolidating your debt with your home’s equity.

2. Creating a safety net

If you experience a financial hardship, you can strategically use an HEL to get through a difficult time. Because your home is the collateral, you can take out an HEL even when facing an emergency.

“Another sensible use for setting up a home equity loan is simply to have a ‘safety net’ in the event of a real financial emergency, such as a job loss,” said McGrath. “For this use, the money is there to use when you hit a tight spot only, and then [should be] repaid quickly.”

An HEL can help you stay current on your bills while you’re job searching. Once you’re back on your feet, you can accelerate your repayment and eliminate the loan.

3. Financing a necessary expense

If you have an expensive and necessary purchase coming up, an HEL can be a useful tool. However, the key word is “necessary.” An HEL shouldn’t be used for something like a vacation — it’s too much of a risk.

Instead, HELs are best used for things you have to have right now, even if you don’t have the money saved.

For example, if a storm damaged your roof, you need to fix the roof as soon as possible to prevent further damage. If you don’t have the money saved, an HEL would allow you to fix your home at a lower interest rate than a credit card or personal loan.

Dangers of home equity loans

The reason HELs need to be used so carefully is because the risks are serious. Here’s what you risk if you take out an HEL.

1. You could lose your home

With an HEL, your house is your collateral. If things go wrong, you could end up losing it.

“If you stop making your minimum required payments on the loan, the bank can and will foreclose and you will likely lose your home,” said McGrath.

2. Your home’s value could decline

There’s no guarantee that your home’s value will increase or even remain the same. If your home’s value significantly decreases, you could owe more on your mortgage than the house is worth.

In that situation, even if you sold the home, you’d still owe money on the mortgage and the HEL, which can be financially crippling.

3. You might get deeper into debt

Although HELs are often a more cost-effective choice than other forms of debt, they are still debt.

“[It’s dangerous] when you haven’t first established a plan for how and when you will use that loan to improve your overall financial position,” said McGrath.

Without understanding how you got into debt in the first place and developing a repayment strategy, you could rack up more debt with an HEL on top of your other accounts. Instead, prepare ahead of time and come up with a budget, change your spending habits, and develop a loan repayment plan to stay on top of your finances.

Getting a loan

If you’re looking for a low-interest way to consolidate debt or finance a large expense, HELs can be a wise choice. However, make sure you know the risks involved and have a plan in place to manage your debt. Otherwise, you could end up losing your home.

If a home equity loan sounds too risky for you but you still need a loan, research your unsecured personal loan options.

Interested in a personal loan?

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1 Includes AutoPay discount. Important Disclosures for SoFi.

SoFi Disclosures

  1. Terms and Conditions Apply: SOFI RESERVES THE RIGHT TO MODIFY OR DISCONTINUE PRODUCTS AND BENEFITS AT ANY TIME WITHOUT NOTICE. To qualify, a borrower must be a U.S. citizen or permanent resident in an eligible state and meet SoFi’s underwriting requirements. Not all borrowers receive the lowest rate. To qualify for the lowest rate, you must have a responsible financial history and meet other conditions. If approved, your actual rate will be within the range of rates listed above and will depend on a variety of factors, including term of loan, a responsible financial history, years of experience, income and other factors. Rates and Terms are subject to change at anytime without notice and are subject to state restrictions. SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income Based Repayment or Income Contingent Repayment or PAYE. Licensed by the Department of Business Oversight under the California Finance Lender Law License No. 6054612. SoFi loans are originated by SoFi Lending Corp., NMLS # 1121636. (www.nmlsconsumeraccess.org)
  2. Personal Loans: Fixed rates from 5.49% APR to 14.24% APR (with AutoPay). Variable rates from 5.29% APR to 11.44% APR (with AutoPay). SoFi rate ranges are current as of December 1, 2017 and are subject to change without notice. Not all rates and amounts available in all states. See Personal Loan eligibility details. Not all applicants qualify for the lowest rate. If approved for a loan, to qualify for the lowest rate, you must have a responsible financial history and meet other conditions. Your actual rate will be within the range of rates listed above and will depend on a variety of factors, including evaluation of your credit worthiness, years of professional experience, income and other factors. Interest rates on variable rate loans are capped at 14.95%. Lowest variable rate of 5.29% APR assumes current 1-month LIBOR rate of 1.34% plus 4.20% margin minus 0.25% AutoPay discount. For the SoFi variable rate loan, the 1-month LIBOR index will adjust monthly and the loan payment will be re-amortized and may change monthly. APRs for variable rate loans may increase after origination if the LIBOR index increases. The SoFi 0.25% AutoPay interest rate reduction requires you to agree to make monthly principal and interest payments by an automatic monthly deduction from a savings or checking account. The benefit will discontinue and be lost for periods in which you do not pay by automatic deduction from a savings or checking account.

2 Important Disclosures for Citizens Bank.

Citizens Bank Disclosures

  1. Personal Loan Rate Disclosure: Variable rate, based on the one-month London Interbank Offered Rate (“LIBOR”) published in The Wall Street Journal on the twenty-fifth day, or the next business day, of the preceding calendar month. As of August 1, 2017, the one-month LIBOR rate is 1.23%. Variable interest rates range from 6.02% – 15.97% (6.02% – 15.97% APR) and will fluctuate over the term of your loan with changes in the LIBOR rate, and will vary based on applicable terms and presence of a co-applicant. Fixed interest rates range from 5.99% – 16.24% (5.99% – 16.24% APR) based on applicable terms and presence of a co-applicant. Lowest rates shown are for eligible applicants, require a 3-year repayment term, and include our Loyalty and Automatic Payment discounts of 0.25 percentage points each, as outlined in the Loyalty Discount and Automatic Payment Discount disclosures. Subject to additional terms and conditions, and rates are subject to change at any time without notice. Such changes will only apply to applications taken after the effective date of change.
  2. Loyalty Discount: The borrower will be eligible for a 0.25 percentage point interest rate reduction on their loan if the borrower has a qualifying account in existence with Citizens Bank at the time the borrower has submitted a completed application authorizing us to review their credit request for the loan. The following are qualifying accounts: any checking account, savings account, money market account, certificate of deposit, automobile loan, home equity loan, home equity line of credit, mortgage, credit card account, student loans or other personal loans owned by Citizens Bank, N.A. Please note, Citizens Bank checking and savings account options are only available in the following states: CT, DE, MA, MI, NH, NJ, NY, OH, PA, RI and VT. This discount will be reflected in the interest rate and Annual Percentage Rate (APR) disclosed in the Truth-In-Lending Disclosure that will be provided to the borrower once the loan is approved. Limit of one Loyalty Discount per loan, and discount will not be applied to prior loans. The Loyalty Discount will remain in effect for the life of the loan.
  3. Automatic Payment Benefit: Borrowers will be eligible to receive a 0.25 percentage point interest rate reduction on their student loans owned by Citizens Bank, N.A. during such time as payments are required to be made and our loan servicer is authorized to automatically deduct payments each month from any bank account the borrower designates. Discount is not available when payments are not due, such as during forbearance. If our loan servicer is unable to successfully withdraw the automatic deductions from the designated account three or more times within any 12-month period, the borrower will no longer be eligible for this discount.
7.39% - 29.99%$1,000 - $50,000Visit Upstart
5.29% - 14.24%1$5,000 - $100,000Visit SoFi
8.00% - 25.00%$5,000 - $35,000Visit Payoff
5.99% - 16.24%2$5,000 - $50,000Visit Citizens
5.99% - 35.89%$1,000 - $40,000Visit LendingClub
5.25% - 14.24%$2,000 - $50,000Visit Earnest
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