You may have heard that home equity loans often carry lower rates than personal loans and credit cards. Even better, the interest you pay on home equity loans can be tax-deductible. So, when should you consider getting a home equity loan and what can you do with one?
How home equity loans work
A home equity loan typically carries a lower interest rate than other loans because it’s backed by your home. It’s called a home equity loan because what matters most is the equity you have in your home, that is, the difference between what you owe on the mortgage and the property’s market value.
For a loan to make sense for the lender, your equity has to be above a certain threshold in relation to your home’s value. Typically, lenders limit what’s called your loan-to-value ratio, or LTV, which includes any first mortgage and any home equity loans. The measure helps the lender determine how risky it might be to give you a home equity loan, given that real estate prices can change, sometimes rapidly.
To qualify for a home equity loan from a lender like Point West Credit Union, your loan-to-value ratio can be as high as 90%. That means you can borrow up to 90% of the property’s market value. The LTV limits can vary by lender, product and even by borrower.
Along with their advantages, home equity loans may come with certain drawbacks:
- Though interest rates are typically relatively low, you may be required to pay application and origination fees, or for an inspection or appraisal of your property.
- If you get too far behind on payments, you could lose your home to foreclosure.
- If your home value drops significantly, you can end up “underwater,” owing more on your property than it can fetch in a sale. This can make it very difficult to move, if, for example, you need to take a job in a far-off location.
Using a home equity loan
Some uses of a home equity loan are often considered better than others. Here are some smart ways to take advantage of your equity:
- Making certain kinds of home improvements or critical repairs can help ensure you get the best price you can, should you decide to sell the property.
- Because rates are relatively low, those with significant debt that has higher interest rates, such as personal or student loans and credit card balances, can pay them off and consolidate the amount owed to simplify payments and cut costs.
- School costs that can’t be covered by savings, scholarships, income or education loans.
- Bankrolling a new or successful small-business venture. But watch out if the endeavor is struggling — staking your house as collateral is a high-risk move.
- Medical expenses or emergency situations that aren’t covered by insurance.
In all of these cases, it’s important to make sure that using and repaying a home equity loan is part of a broader plan that keeps you financially healthy.
Devan Goldstein, NerdWallet
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