A home equity loan is a consumer debt taken for the purchase or renovation of a property. It may also be called an equity loan, a home equity instalment loan, or a second mortgage. Basically, it is a loan given by the financial institution against the appreciation in the market value of your property.
You as a borrower can take a home equity loan even when you have an outstanding home loan against your property. In such cases, the lender, to arrive at a loan value, will assess the current market value of the property and deduct the outstanding loan amount. Around 50-60% of the home value is expected to be eligible as the loan amount.
Although home equity loans might be beneficial, they can also be a debt trap because they erode your home’s equity value. If you don’t pay, your lender may foreclose on your home – meaning, you may lose your existing home. This guide will help you decide if taking out a home equity loan is the correct decision for you by explaining the basics of home equity loans.
Advantages of a Home Equity Loan
Lower rates: You may possibly be able to bargain for a better interest rate to suit your budget. The interest on a secured loan – one backed by collateral – is generally lower than one on an unsecured loan with no collateral. Considering the current interest rate market and the upcoming festive season, the interest rates for home loans are low.
Large sums of money: Home equity loans are likely to provide more money than any other source, including personal loans and credit cards.
Flexibility: House equity loans can be used for any purpose, it could be for a house repair or renovation, or luxurious vacation, or even as seed capital for a business.
Tax benefits: When you file your taxes, you can deduct the interest on the loan should the loan be used towards the purchase of new property or renovation of the old.
Downsides of a Home Equity Loan
Risks: As your house property is provided as collateral in home equity loans, in case of series of defaults in payments, the lender has the right to take possession of the property. And if it already has an outstanding loan, then the lenders may auction the property as well.
Closing fees and costs: A home equity loan can be used as a second mortgage. Closing expenses are pricey, just like your primary mortgage. If you pay off the loan before time, you may be charged an early termination fee.
Interest rate fluctuations: While banks and financial institutions offer both fixed and floating interest rates, most banks provide floating interest rates to their borrowers. Going for a floating interest could be beneficial in declining interest rate markets and can pinch your pockets when interest rates rise. Same scenario if you choose fixed interest rate.
Home equity loans eligibility criteria
Home equity loans work in the same way that a mortgage or auto loan does. The borrower is given a lump sum of money that must be repaid over a certain period as EMI (equated monthly instalments).
In terms of approval, a home equity loan gets approved if a borrower provides documents (such as salary slip or other savings) to state his/her ability to repay. Lenders usually use credit reports and credit scores to verify borrowers financial position. Your credit will be thoroughly scrutinised before the loan is sanctioned. Depending on your financial merit, the entire procedure may take a few days or a few weeks to process.
Keep in mind that interest rates could be floating or fixed. So when you are looking to avail of home equity loans, you should shop around with banks and other financial institutions. Lenders don’t want to take chances, you shouldn’t either.
What should borrowers do?
If you are in urgent need of money for business purposes or for house repairs, then home equity loans are an option. This is provided if you know how much you want to borrow, supported by a sufficient monthly flow of income to pay off the EMI. Since it is secured by your house, the cost of loans in terms of interest rates and processing fees could be lower when compared to a personal loan.
On the other hand, when you already have a loan on your house property, then it is best to avoid taking further loans, it may weigh down your finances.