Home Equity Loans Aren’t Guaranteed Financial Disasters

Home equity — it’s a dream so many Americans gave up on after the real estate crash in 2006, but now, nine years later, we’re starting see equity rising once again. In fact, over 80 percent of all mortgaged homes currently have at least 20 percent of their value in equity, with the average loan to value sitting at 58.9 percent as of Fourth Quarter 2014. This means several things, actually, and many of them are great news for anybody who has gotten sick and tired of their worn-out kitchen, cave-like bathroom or just have an urge to add a personal touch to their surroundings:

  1. This much equity tends to point to rising market values. I know, you’ve heard it over and over again, but the market is actually rebounding, I swear. When I started writing for US Mortgage Calculator, I was just as skeptical as you are that it would ever get better — but little by little, things are starting to finally balance.
  1. The data could indicate that people are bringing larger down payments to closing.  This scenario is unlikely to make up a huge part of the picture since only a limited sector of the market would be bringing a 40 percent down when there’s just not that much benefit to doing so.
  1. Most importantly, I think, a housing market with an average of more than 40 percent equity means that people are staying in their homes longer. This is bad and it’s good — low rates and a fear of an unstable market are keeping people in their homes, but staying in your home also means that you’re not contributing to market churn. This may become the new normal and that will be OK — provided you’re always buying with the future in mind.

A Brief History of Home Equity Loans

I’m not actually going to bother to go back to the beginning on home equity loans, but I do want to take you back to the early to mid 2000s so I can explain why your parents, friends and neighbors may be warning you against considering a home equity loan. Back then, the market was so explosive that homes in some areas would see thousands of dollars in equity gains in a month — I’m not even exaggerating.

Homeowners became convinced the equity party would never end, so they started cashing it out and spending that found money on luxuries, vacations and other random junk that would never be worth what they paid for it. Homeowners as a whole figured that in the worst case scenario they’d pay off the home equity loan when they sold their home in a few years for an enormous profit. Unfortunately, a lot of homeowners found themselves stuck holding the bag when the bubble burst, long after that big screen TV was old technology and the vacation little more than snapshots on Facebook.

This is why home equity loans have earned such a bad reputation. A lot of people didn’t understand the product and they got burned. It’s very simple. So if you’re considering a home equity loan, make sure you’re doing it for the right reasons and that you’re getting the right product. Learn everything you can about your home equity loan and assume you’ll have to pay back every red cent. That’s how you use them, that’s how you don’t get burned.

Types of Home Equity Loans

Now that we’ve got that settled, there are a couple of types of home equity loans that you may encounter. Both draw off the same home equity and are treated as second mortgages. A second mortgage is what you have when you’ve already got a loan on your home, but take out another with the remaining equity. When you sell your home, the primary loan (the first) is paid off first, then remaining proceeds are used to pay off the second. Anything left goes into your pocket.

Both home equity loans and HELOCs originate in much the same way on a basic level, drawing on your equity to provide you with cash funds. The differences lie in the way they function:

Home equity loans are taken out in one big lump. You get a check for up to whatever amount of your equity the lender is willing to give you (currently, that’s about 90 percent) — and you take that $5,000, $10,000 or $50,000 check to the bank and cash it. You also start making payments on the full amount pretty much right away. This is a very basic loan, nothing fancy about it.

HELOC is a little less straight-forward and can be much more frustrating for homeowners. There’s a great deal of merit in it, too, so don’t dismiss it just because it’s a little more complicated. HELOC stands for home equity line of credit — and that’s exactly what it is. Think of it like a credit card, if that helps. Like a credit card, you have a limit, determined by your home’s equity, and you’re going to pay installment payments based on how much you’ve borrowed.

Unlike a straight home equity loan, you can take out part of the HELOC and go back for more later — say, if you’ve got multiple projects planned, but only want to fund them one at a time. So, this month you do the bathroom and six months from now you tap your HELOC again for more money to straighten out your kitchen counters. Each time you borrow from your HELOC, the terms will be the same as the initial loan, just like with a credit card.

HELOCs or Home Equity Loans?

There’s no such thing as a one size fits all loan, otherwise the home equity loan would have been the only type of second you could take out on your home. The product you choose is highly dependent on how you intend to use it and whether you think you’ll need to tap your home’s equity again.

Let’s compare the average HELOC and home equity loan side by side, shall we?

Home EquityHELOC
Interest RateFixedAdjustable
Minimum PaymentPrincipal plus interestInterest only on what you’ve tapped during draw period
Prepayment PenaltyNoneNone
Appraisal RequiredAt closingAt closing, not required for individual draws
Access to Additional FundsRefinance requiredCan tap funds up to a pre-set maximum during draw period

As you can see, the two loans are fairly similar. Neither is designed to gouge you with interest, but the HELOC does have a floating rate, based on the Prime rate. Where things go a little sideways is if you anticipate needing to tap your home more than once for cash — that’s the situation where HELOCs shine. During the draw period, usually the first 10 years, give or take, you can borrow small amounts from your HELOC whenever you need them. You don’t start making payments on any borrowed funds (also known as draws) until you actually borrow them.

For example, you could start your HELOC with a $5,000 draw, and use that to refurbish your landscape, leaving $20,000 untapped. For now, you only pay on the $5,000 — when you go to tap the loan again for that $4,000 fence you’ve been needing, you’ll start paying on the total of $9,000, and so forth. On a HELOC, you’ll be cut off from borrowing at the end of the draw period and will have to start paying both interest and principal on what you’ve drawn over the years.

Home equity loans are great for large projects — especially if the work will all be done about the same time and you don’t anticipate revisiting it for a while. Going back to the example above, you’ll be making the same payment on the whole of your original $20,000 loan from the moment you take it out until it’s paid in full, so there’s not a huge financial surprise down the road. Many homeowners appreciate the predictable nature of the home equity loan, even if they end up holding some amount of their borrowed funds in reserve.

How to Use a Home Equity Loan or HELOC

Although you’re allowed to buy anything you want with the money you borrow from your equity, remember that you’re still taking out a significant loan against your home. This is not a situation to enter into lightly. Consider very carefully if the purchase you’re going to make is actually worth risking your home and if it will return at least as much as you paid. Common reasons for tapping home equity include things like paying for a child’s college, purchasing vehicles, travel and those luxury goods we discussed above. All of these are horrible things to spend your equity on.

There, I said it. Even something as important as an education is not a reason to tap your equity — even if your kid goes on to become a brain surgeon, you’ll be on the hook for those funds well into your retirement, putting your one and only home at great risk of repossession. Finance education with educational loans — leave your home out of it.

If, however, you bought a fixer with some equity already in place, want to modernize your kitchen or bath or simply need to make improvements that make your home work better, a home equity loan is definitely for you. Depending on how long you’ll be in your home, some improvements are better than others, but at least that extra monthly payment is going to something that gets you immediate satisfaction and may help you stay in your home well into your old age. This is exactly what a home equity loan was designed to do.

Bottom Line: A Home Equity Loan is Ideal for Long-Term Homeowners

Unlike many types of loans that were designed purposefully to take your money and leave you a crumpled heap of your former self, home equity loans and HELOCs were designed to help homeowners. Every home, at some point, has a major expense come up — and finding the deep pockets to fund a new roof, replacement windows or an addition for that surprise set of twins is a trick for most people.

Fortunately, you’ve been paying faithfully on your home for a while now and have slowly built up some equity to help cover those big ticket items. All you have to do is decide if your future projects or expenses are going to be a one time thing or if you’ll need to borrow money over a long period to accomplish your mission. Whatever you do, weigh your options carefully — that sudden payment change at the 10 year mark on the HELOCs can be dangerous for the unprepared.

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