Home equity loans or lines of credit are financial tools available to homeowners as you begin to pay off your a mortgage and your home’s value continues to rise. You can use them to consolidate debt, finance a large purchase or project, or simply serve as a source of backup funds should you need them.
However, these tools don’t come without risk. For more home equity loan information, make sure to read our guide below.
What’s the Difference Between a Home Equity Loan and Line of Credit?
Home equity loans and lines of credit both involve using your ownership in your home to secure access to funds. That is, as you pay down your mortgage, you gain additional equity in your home. When you apply for a home equity loan or line of credit, your lender will examine how much you still owe on your mortgage as a percentage of your home’s total value.
There are some differences between home equity loans and lines of credit, though, such as how a homeowner accesses the funds given by the lender. With home equity loans, your financial institution will lend a specific amount of money at the beginning of the term.. The loan will likely have a fixed rate and term, which. This means you’ll pay back the same amount every month until the principal and interest of the loan have been repaid.
A home equity line of credit, or HELOC, works similarly to a credit card or standard line of credit. Instead of being handed a lump sum that, you have to start paying back immediately, a HELOC affords you the ability to only withdraw money as you need it. Because the line of credit is secured by your home, most people will have access to higher amounts at lower interest than they would with a credit card.
Since a HELOC is a revolving line of credit, you can withdraw money as you need it, and you’ll only pay interest on the amount withdrawn. When you pay back the balance, that amount again opens up for you to deposit into your checking account or otherwise spend.
For example, let’s say your HELOC has a maximum credit line of $50,000. If you withdraw $10,000 to pay for a home improvement project, you’ll only pay interest, usually at a variable rate, on the $10,000 you’ve withdrawn. Once you pay back the principal and interest on the $10,000, you’ll again be able to withdraw up to $50,000.
How Much Equity Do You Need?
Perhaps one of the most fundamental home equity loan facts is that they require equity in your home. To determine how much they can lend, most financial institutions will look at your current and potential loan-to-value ratio or LTV. Your current LTV is the amount of your mortgage that’s still owed divided by the current home value. Your potential LTV includes both your current mortgage and your potential HELOC or loan in the numerator.
Most lenders will cap the amount they can lend based on an 80% LTV. That is, they won’t loan you an amount that would cause you to have a mortgage and HELOC or loan that combined make up more than 80% of your home’s value. This limit helps reduce the amount of risk the financial institution takes.
What are the Risks of a Home Equity Loan?
HELOCs and home equity loans are fantastic financial tools to consolidate debt, as well as, secure financing for home improvement projects or other large purchases.
However, because these tools are secured by your home, you face significant risk should something happen that affects your equity or ability to pay back the loan or line of credit. If you take out too much money as a HELOC or loan and your home begins to lose value, you could find yourself underwater. That is, the amount you owe on loans secured by your house is more than the home’s value.
If you enter a situation where you are unable to make payments to your HELOC or loan, you also risk losing ownership of your home. So, while the lower interest rates are advantageous , a HELOC or loan could make your financial issues much worse.
How Do Rates Usually Compare to Other Options?
As stated earlier, home equity loans or lines of credit usually have lower interest rates than other, unsecured forms of lending, such as standard lines of credit or credit cards. This allows HELOCS or loans to be advantageous when it comes to tackling debt.
However, these financial tools also typically carry a higher interest rate than a first mortgage. That’s because HELOCs or loans are considered second mortgages. That is, they have the second claim on your home should it be foreclosed. Once the first mortgage company is paid out in full, anything leftover would be given to the second mortgage company. So, financial institutions offering HELOCs or loans use higher interest rates to help cover the risk of not being paid back in full.
Is the Interest Tax Deductible?
Another benefit of securing a HELOC or loan is that the mortgage interest may be tax-deductible. Those married and filing jointly can deduct interest on a loan up to $100,000. For those single or filing separately, the maximum deduction is $50,000.
Of course, by deducting interest payments from your tax responsibility, you can save yourself thousands of dollars. Unfortunately, to claim this tax break, you have to itemize your deductions. Only a small percentage of households take this route with their taxes as the majority takes the standard deduction.
You’ll need to work with a certified accountant or tax expert to determine your specific tax savings. Knowing your potential tax bill can help you save money and make an informed decision involving your finances.
Contact Blackhawk Bank Today!
When it comes to a HELOC or loan, there are plenty of advantages. From consolidating debt, financing large purchases or projects, or securing backup funds for life’s transitional periods, you’ll be able to make your equity work for you! With the additional benefits of low-interest rates and tax-deductible interest payments, these financial tools can help you save money and tackle debt, too.
Call Blackhawk Bank today at 1-800-209-2616 to go over what you should know about home equity lines of credits and loans. We can also help you apply and go over any lending requirements.
Featured Image: Shutterstock / Vitalii Vodolazskyi
Tammy Zurfluh, SVP Mortgage Banking