Home equity loans are a very popular way to borrow money, but if you are a newcomer to this type of credit it is important to do some research before committing. For some, a simple definition of terms is a great place to start. So, just what is an equity loan?
A home equity loan is like any other type of application for credit; a check of your credit rating may be required even if you have made all your mortgage payments on time. Your good standing on the original loan will count in your favor, but other factors including your debt-to-income ratio may affect your eligibility for a home equity loan.
define: Equity
Equity is a term referring to the value of your home compared to the amount you still owe on the original home loan. When you first purchase a home, your equity can be extremely low (or nonexistent) because you haven't had time to make payments to reduce the amount you owe.
New home owners may watch their property increase in value over time, depending on the local market. That increase in value also provides equity. This increased value, combined with your mortgage payments, eventually adds up to an amount you may be tempted to borrow against.
Possible perks
Home equity loans have some attractive perks. According to Kiplinger.com you may be able to deduct the interest on a home equity loan within certain limits set by the IRS. The interest on the first $100,000 of a home equity loan may be written off, effectively making your home equity loan interest-free for any amount under $100,000.
Tax laws are subject to change; before making a decision on a home equity loan based on tax implications, double check the tax code to make sure this perk applies to you and is in effect for the current tax year.
Possible uses
Once you are approved for a home equity loan, there are a lot of ways you can spend the money. Many credit experts say investing in home improvements with your home equity loan is a powerful use of the money; you increase the value of your home and avoid paying outright for that investment.
Are you considering a big-ticket purchase such as a new refrigerator/freezer or stove? Any appliance you plan to include in the sale of your home potentially increases the value. These items may not directly increase your equity, but if you consider selling the home later down the line these appliances could be viewed as an investment to make your home more attractive to a potential buyer.
Using a home equity loan to pay off credit cards or other bills is another way some home owners use their loan, but this can be a risky proposition. If your home goes down in value for any reason, you risk owing more than the home is worth with the combined weight of the original mortgage and the new loan.
Other considerations
It is important to remember that rules for home equity loans are much like any other type of credit. A home equity loan uses your house for collateral. If you fall upon hard times and wind up defaulting on the loan, you could lose the collateral; an important factor to consider before taking out a large amount of money against your property.
Another factor to keep in mind is changing interest rates. Your home equity loan rates may rise, and if your original mortgage is also on a variable interest rate, both payments could go up while your income remains the same. Those who are eligible to take the applicable tax break on the interest from the first $100,000 may not feel the sting of those increased rates, but if you are contemplating a larger amount it is important to make room in your budget for any potential increase.
A home equity loan can be used as a tool to increase the marketability of your home, a way to purchase expensive items or features for the house or as a way to generate capital for other needs such as legal expenses or other real estate investments. What you do with the money is up to you once you're approved; explore your options and make the most financially sound use of your new line of credit.
If you have a specific purpose in mind for your home equity loan but aren't sure about the risks, ask your loan officer for some advice—you may learn a great deal from the mistakes of other borrowers. Chances are your loan officer has seen plenty of good and bad uses for the loans they approve and can give you some excellent advice about your specific situation.
See also: Home equity loan or line of credit – Which is the best option?
