What You Should Know Before Taking Out a Home Equity Loan
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Let’s be real—housing is expensive and if you own a home, you’ve probably experienced the financial strain of homeownership firsthand. But here’s the good news: with a home equity loan, you can access some of the money you’ve already paid towards your home.
However, before you start filling out applications for home equity loans, it’s important to understand the details of this specific type of loan. For starters, let’s back up a bit. Housing is the second biggest annual expense for most Canadians (taxes are No.1). This means that your mortgage is likely the biggest loan you’ll ever get in your lifetime and as a result, it’s also your largest asset. But here’s the potential problem with an asset that isn’t easily accessible in the form of cash.
With your money tied up in your house, it may be challenging to afford other expenses, like home repairs or care for aging parents. This is where a home equity loan can come in handy.
Still confused about exactly how a home equity loan can help you out? Luckily, we’re here to help you learn more about this type of loan.
What is a Home Equity Loan?
Let’s start by defining “equity.” Equity is the difference between how much your home is worth and your unpaid mortgage balance. For example, if your home is worth $500,000 and you still owe $200,000 on your mortgage, then you have $300,000 in equity.
Home equity loans, in turn, allow you to borrow against the equity you’ve built in your home. You do this by taking out a loan and using your home as the collateral. There are two main ways to access your home equity.
- Home equity line of credit (HELOC): HELOCs work like a secured credit card in the sense that you can access the money when you need it and only pay back what you spend. HELOCs typically have variable interest rates that may change as the market rate changes.
- Second mortgage: Second mortgages function similarly to other loans. The full amount of the second mortgage will be deposited into your account in one lump sum and you’ll be responsible for paying it all back. The interest rate may be fixed or variable but is typically a little higher than the rates for first mortgages.
The premise for both types of home equity loans is similar – you get monetary access to the equity you’ve built in your home.
Things to Know Before Taking Out a Loan
If you’ve determined that a home equity loan may be a good idea, here are 3 things you should know before you take out the loan.
1. There are limitations on what you can borrow
Regardless of what type of home equity loan you choose, you’ll be limited in how much equity you can access. This means that you cannot access 100% of the equity you’ve built in your home, which is important to note before you start making plans to spend the newfound cash. The rules are a little different depending on the type of loan you choose.
If you decide to apply for a second mortgage, for instance, you can be approved for up to 80% of your home’s appraised value, minus what you still owe on the mortgage.
So, if your home is worth $200,000 and you still owe $100,000 on your mortgage, this leaves you with $100,000 of equity in your home. Yet, you won’t be approved for a $100,000 second mortgage. Instead, you’ll be approved for 80% of the home’s value, minus what you owe on the mortgage. In this instance, 80% of your home’s value would be $160,000. After subtracting what you still owe on the mortgage, which is $100,000, you can expect to get approved for a $60,000 second mortgage.
If you decide to apply for a HELOC, you can get approved for 65% to 80% of your home’s appraised value. Using the same example, you can potentially be approved for a HELOC between $130,000 and $160,000.
2. Lenders look at a variety of factors
Once you’ve decided that you want to apply for a home equity loan, your next step is to actually apply. In general, the application process is fairly straightforward. Here are three things lenders will typically consider when reviewing your application.
- Equity: Lenders will look at how much equity you have in your home. This is important because it will determine the size of your loan.
- Credit score: Lenders typically look at your credit score to determine your interest rate, but don’t let that deter you from applying for a home equity loan. It’s only one of the many factors lenders consider.
- Income: In order to ensure that you’ll be able to make the loan payments, lenders typically look at your annual income. Even though this may sound intimidating, it’s actually a good thing because it ensures that you won’t be given a home equity loan that is too big for your budget.
3. It will alter your budget
It may seem like common sense, but it’s important to note that a home equity loan will alter your monthly and yearly budget. If you decide to take out a HELOC, you will be responsible for paying back whatever you spend. Similar to a credit card, you’ll have a maximum spending limit, which is the amount of the home equity loan. After spending the money, you’ll be responsible for monthly payments until the loan is paid off.
If you opt for a second mortgage, you’ll essentially have a second mortgage payment each month. The payment will be a different amount than your original mortgage, but you’ll still be required to pay it every month. In the same way, you can lose your home if don’t make your mortgage payments, you can potentially lose your home if you fall behind on home equity loan payments as well. Because of this, it’s a good idea to factor your future home equity payments into your budget prior to taking out a loan.
Your home is likely your biggest asset. Yet, with so much of your hard-earned money poured into your down payment, there may come a time when you need a loan to help you get by. By doing your research and fully understanding the ins and outs of a home equity loan, you’ll be on your way to borrowing money against the value of your own home.