Real estate appreciates over time. Consider the fact that Dutchman Peter Minuit sold the island of Manhattan for the rock bottom price tag of $24 nearly 400 years ago (in 1626), which, in 2014 dollars, is now estimated to exceed $1.7 trillion in 2014 dollars, according to well-respected economic gurus.
History has taught that if a real estate investor (or any homeowner for that matter) has the time to wait, a real estate investment is likely to morph into an intelligent financial decision. Essentially, real estate’s intrinsic appreciation (over time) sets up a favorable situation where homeowners have the opportunity to take advantage of the equity created by that very appreciation. Historically, homeowners have found that the equity created by their primary home’s property appreciation helps finance their children’s education, retirement, a property upgrade, or any other need as the borrower sees fit.
As a homeowner, one of the most prudent ways to access needed funds/capital is to use the funds that were used by a homeowner as a down payment when purchasing a home, or the equity created by the property’s appreciation. Equity is simply calculated as follows –
The Home’s Current Market Value – Any Outstanding Debt/Liens on the Property = The Equity in a Property
Homeowners can access their home’s equity by applying for –
- A HELOC – a Home Equity Line of Credit on a primary residence, or
- A Home Equity Loan on your primary residence.
It is noted that some of the more lenient lenders may offer home equity financing on a second home or investment property, but this is not generally the norm.
Both the HELOC and a home equity loan, offer homeowners a legitimate financing option when in need of cash or capital. However, each of these equity financing options works differently from one another. Homeowners should understand the difference before deciding which type of home equity financing may be best suited for their specific financing needs.
It is noted that most home equity loans or lines of credit are considered second mortgages as they are most often obtained in addition to the first mortgage that was used to purchase the real estate.
However, both the HELOC and the home equity loan may be placed as a first position lien if there is no other financing present on the property. A first position, HELOC or equity loan, would undoubtedly make the loan more attractive to the lender.
From a risk perspective, a second mortgage is considered riskier than a first position lien. This is because when foreclosure occurs for nonpayment, the second position lien is only repaid after any unpaid taxes, and the balance of the first mortgage has been satisfied.
The Home Equity Loan
The Home Equity loan closely resembles most traditional, fully amortizing loans. The loan amount requested, when approved, is provided to a homeowner as a lump-sum amount, minus the lender’s closing fees if any.
Should the proceeds of the home equity loan be used to consolidate debt, the lender may cut checks at closing to pay off the debt earmarked for payment by the loan’s underwriter. Similar to standardized loans, a home equity loan begins to accrue interest upon the closing of the loan, with the most monthly interest being paid during the first portion of the loan term.
A home equity loan is collateralized by the property pledged. An equity loan may allow borrowers to deduct the interest paid on the loan – it depends upon how a borrower uses the home equity financing. Borrowers should speak with a tax expert to determine the tax-deductibility of home equity interest for their specific circumstances.
Borrowers are required to pay fixed monthly installments of principal and interest on the home equity loan balance for the agreed-upon term of the loan. Terms can range from 5 years to 30 years, with most home equity loans offering an average term of 10 – 15 years.
Additionally, a home equity loan is generally available as a fixed rate or an adjustable-rate mortgage/loan. And, as a general rule, interest rates on collateralized loans, like a home equity loan, have lower interest rates than the rates charged for unsecured loans, personal loans, and credit cards.
Home Equity Loans – Pros
The home equity loan advantages are as follows –
- Lower Rates and Low payments – collateralized loans offer lower interest rates and attractive terms.
- Large Loan Amounts – loan amounts for home equity loans exceed limits on personal loans or credit cards.
- Potential Tax Benefits – home equity funds used for home improvement are generally tax-deductible – check with a tax advisor.
- Flexibility – borrowers can use the funds to pay for college, improve one’s home, or fund retirement, to name a few options. There are no conditions for the use of the money unless the underwriter requires existing debt to be paid in full as a closing condition of the equity loan.
Home Equity Loans – Cons
- Risk –the home equity loan is secured by one’s home; this property can be foreclosed upon for nonpayment.
- Closing Costs – equity financing is more expensive to close than a personal loan. Closing costs, however, can be funded through the loan’s proceeds.
- Going Underwater – if one taps into equity and the home’s value declines, they may owe more than the home is worth. This makes it super challenging to sell a home, without cooperation from the lending institution.
The Home Equity Line of Credit (HELOC)
The Home Equity Line of Credit (HELOC) taps into the equity in real estate in a way that more closely resembles how a credit card behaves. HELOCs have been developed as a financial instrument that permits homeowners to borrow and then re-borrow the available funds in a pre-determined line of credit that is secured by the pledged property.
HELOCs differ from home equity loans as interest does NOT start accruing until the borrower uses funds from the secured line of credit. As such, it is possible to open a HELOC and not use the money until sometime after the closing – accruing no interest until the time the funds are used. In this way, a HELOC is a great tool to fund a homeowner’s earmarked emergency funds.
A borrower can choose to only borrow a small portion of the line of credit, which is the balance upon which interest is earned.
HELOCs are generally offered with adjustable interest rates; however, some lenders may offer fixed rates to their best customers. HELOCs have a unique structure as they typically have –
- An access period during which funds can be used and reused. Many lenders give borrowers the option to pay interest-only during the access period. A typical access period runs ten years.
- The repayment interval during which the line of credit is closed to further borrowing. The borrower is then given a preset term to repay the balance owed at that time, typically 5 – 20 years. Certain HELOCs have balloon payments, which require large lump sum payments at the end of the loans’ term. Be certain to understand the complete terms of the equity financing before executing the paperwork at closing.
Home Equity Lines of Credit (HELOCs) – Pros
The advantages of a home equity loan are as follows –
- Lower Rates than unsecured loans or credit cards.
- Large Lines of Credit Available – HELOCs maximum limits far exceed limits for personal loans or credit cards. HELOCs can max out as high as $1,000,000, and even higher from certain lenders.
- Potential Tax Benefits – HELOC funds used for home improvement are generally tax-deductible – check with a tax advisor.
- Flexibility – borrowers can use the funds to pay for college, improve one’s home, or fund retirement, to name a few options.
- Interest accrues on only the outstanding balance, not the total credit line maximum.
Home Equity Lines of Credit (HELOCs) – Cons
- Overall Risk –HELOCs are secured by the property, which can be foreclosed upon for nonpayment.
- Rate Risk – HELOCs are generally offered as adjustable-rate mortgages. Payments can change when interest rates change.
- Closing Costs – equity financing is more expensive to close than a personal loan. Closing costs, however, can be funded through HELOCs proceeds.
- Going Underwater – if one taps into equity and the home’s value declines, they may owe more than the home is worth. This makes it very challenging to sell the home, without cooperation from the lending institution.
Qualifying for a Home Equity Loan or HELOC
Like all mortgages, a borrower must meet the lender’s qualifications to secure a home equity loan or HELOC. Fortunately, this is easily accomplished these days by applying online to a financial institution that offers a home equity financial product that meets one’s needs.
While each lender will establish its own specific set of underwriting guidelines, there are some underwriting generalities that are helpful to understand.
Underwriters are tasked with the responsibility of determining three essential things about a borrower/loan application.
Will the borrower(s) pay the mortgage back as agreed?
This question is answered by evaluating a borrower’s creditworthiness, i.e., a credit score, among other issues. A credit score is an ever-adjusting algorithmic calculation that ‘quantifies’ an individual’s creditworthiness. Credit scores impact everyone’s personal and professional lives.
Borrowers with credit scores above 680 can usually qualify for a home equity loan/line – if they have sufficient equity in the property. A high credit score suggests that an individual will be less likely to default on the loan.
Can the borrower(s) pay the mortgage back as agreed?
This question is answered by evaluating a borrower’s work history and job stability, among other issues. Is the borrower’s income sufficient to meet another mortgage payment each month? Does the borrower’s work history demonstrate job stability?
Will, the value of the collateral (property), cover the mortgage balance should foreclosure be necessary?
This question is answered by obtaining the value estimated by the third-party professional appraiser who valued the property for the lender. The property’s appraised value also determines the maximum loan amount a borrower may qualify for as it is based on certain Loan-to-Value (LTV) maximum limits.
The home equity loan/line amount a borrower may qualify for is contingent upon several factors –
The borrower’s income – each lender sets forth its ratio guidelines regarding a borrower’s income. Many lenders permit a total expense-to-income ratio to be 45 – 50%, although it varies. This means that some lenders will approve home equity loans/lines where a borrower’s total monthly debt is up to half of their verified income.
The property’s available equity – each lender, sets forth its Loan-to-Value (LTV) ratio guidelines. Most lenders max out their home equity loan/limits for LTVs less than 75 – 80%.
A Loan-to-Value is (LTV) calculated by dividing the total outstanding debt on a property by the property’s market value. A borrower who owes $160,000 on a property worth $200,000 would have an LTV of 80% = $160,000/$200,000.
Tapping into the existing equity on a piece of real estate is a prudent financial move when needing cash or capital. However, be certain that the reason for the loan is appropriate as the loan will be typically collateralized by one’s family home.
Borrowers who are uncertain of which loan will be best suited for their particular situation should reach out to a trusted friend, a financial advisor, or a lender for further clarification.
The Tax Cuts & Jobs Act of 2017 (TCJA) advises borrowers to contact tax professionals or accountants to determine the interest paid on the equity loan is eligible for a tax deduction.
Fortunately, there are many home equity options from which to choose. However, not all equity loans and HELOCs are created equal. Borrowers must be vigilant in finding answers to each of their questions before agreeing to any specific home equity offer.