How Do Home Equity Loans Work?
Although second mortgages and home equity loans are technically different, a home equity loan acts like a mortgage. You take out a loan against the equity you've built up in your home, and your home secures the loan.
Consider the following example.
- You bought your home five years ago for $250,000
- You currently owe $200,000 on your mortgage
- The current value of your home is $300,000
Your equity is the current value of your home minus what you owe: $100,000. When you take out a home equity loan, you can usually borrow up to about 80 percent of your home's equity. In this example, you could borrow up to $80,000. You don't need to borrow the maximum, but the lender may impose a minimum loan amount of a few thousand dollars.
Good Reasons to Use Home Equity Loans
Home equity loans should be used as an investment in your future. One of the most common reasons for a home equity loan is a renovation or remodel that adds to your home's value. Adding a bedroom or a swimming pool typically offers the highest returns on investment for major projects.
Another financially sound reason to use a home equity loan is when you need a major repair, such as a new roof or air conditioner. If your emergency fund can't cover the costs, the rate on a home equity loan is often much lower than credit card interest rates. A portion of the interest you pay on a home equity loan may also be tax-deductible, while credit card interest is almost never deductible.
A home equity loan can also help you escape from high-interest credit card debt. However, it's important that you make sure this is an investment in your future — by saving on interest payments — rather than a way to run up additional debt.
Home Equity Loan Uses to Avoid
Home equity loans should never be used as a splurge or for nonessential spending. It can be tempting to buy a new car or take an expensive vacation while expecting future salary increases to pay off the loan, but think about the unexpected.
What happens if you lose your job or have a health emergency? If you take out equity when you don't truly need it, you lose the flexibility to deal with true financial disasters.
What Is a Limited Document Loan?
There are two types of home equity loans: full document loans and low or limited document loans. As with any loan, the lender needs to be reassured that you'll be able to repay the loan. The application process for a home equity loan requires an appraisal of your home's value and proof of income.
A full document loan requires extensive documentation and proof. To cover the costs of obtaining this proof, the average closing cost is around $3,000.
A limited document loan still requires proof, but the review process isn't quite as stringent. Because of this, the average closing cost is only around $800.
When a lender has more information to base their decision on, their risk is usually less. Therefore, interest rates are usually lower on full document loans.
If you're taking out a smaller loan, you may find that your total cost of the loan (interest and closing costs combined) is smaller if you go with the higher interest rate and lower closing cost limited document loan. As the loan amount increases, the interest savings with a full document loan outweigh the higher closing costs of a full -document loan.
You can learn more about loans from TDECU and the application process on our TDECU Mortgage website.