If you need money to remodel your kitchen, bath, or for any other home improvement project, a home equity loan might be your best bet. In this article, we’ll help you understand your options and explain the terms that make these loans seem so confusing.
You don’t need to have your home paid off to get a home equity loan. A second mortgage and a home equity line of credit (HELOC) are both loans that let you borrow money based on your home’s equity, and use your home as collateral. Your equity is determined based on the value of your home and any loans you have against it. Let’s take a minute to explain a couple of those terms in relation to home loans:
- Value- The value of your home is determined by an appraiser, someone who comes out to see your house and compares it to other homes in your area, that are similar to yours. (Sites like Zillow will give you an estimate of what your home is worth… but it’s just an estimate.)
- Collateral- Your home is your collateral for the loan, it’s an item of value that the lender can take back if you fail to re-pay your loan. You get a lower interest rate using your home as collateral because there is a smaller chance that the lender will lose money if you don’t pay your loan back.
- Equity- The value of your home minus the balance of any loan you have on your home, determine your equity. Most lenders will lend up to a certain percentage of the value of your home.
Simple example for determining your home’s equity:
If your home value is $100,000 and your lender finances up to 85% of the value of your home, then $85,000 would be your maximum loan amount. However you still need to subtract any mortgage loans you have. If your mortgage balance is $50,000, then you’d have $35,000 in equity you could use to get a home equity loan. You’ll also want to factor in any closing costs that the lender may charge. If the closing costs are $1000, you’d only get $34,000 in proceeds from the loan, unless you decide to pay your closing costs out of pocket and not include them in your loan.
Closing costs: Each lender charges different closing costs. When you’re determining which lender to use for your home equity loan, make sure you compare closing costs as well as the rate…sometimes paying a higher rate and lower closing costs will save you money in the long run.
Now that you know all about value, equity and collateral, let’s break down the types of loans you can get using your home’s equity:
Second Mortgage:
When you already have a mortgage on your home but you use the equity you have in it to get another loan, it’s called a second mortgage. You borrow one large amount of money that would cover the entire cost of your home project. You’ll pay a fixed rate, which won’t change during your loan. You’ll also pick how long you want the loan for, the longer you go, the lower your payments.
HELOC, also known as a Home Equity Line of Credit:
Much like a credit card, a HELOC is an open-ended loan which means you can borrow money as needed, up to your credit limit. Your monthly payments will change based on your loan balance and rate. A HELOC usually has a variable-rate which can change over time.
Prime Rate: Most HELOC rates are based on the prime rate, which is based off a rate set by the federal reserve. A HELOC rate may also have a floor which means that no matter how low the prime rate drops, your rate wouldn’t go below a certain point. The rate can also be prime plus a margin which is a percentage amount that’s added to the prime rate (ex: prime +1%). The rate factors will depend on the lender.
Tax-Advantage: Both home equity loans can have tax benefits and the interest you pay is likely to be tax-deductible. Make sure you check with your tax advisor to maximize your tax benefits.
Making home repairs or major improvements using a home equity loan can make sense financially since they can help increase the value of your home. Choosing the type of loan you get, is up to you and your needs. In summary, if you’re looking to borrow one amount and want to get a set rate and payment that won’t change, then a second mortgage is probably the route you’d want to go. However, if you want to be able to get money at multiple intervals and have a payment based only on what you owe at the time, giving you the option to do other projects in the future, then a HELOC may be your best bet.
Talk to a home loan specialist at Public Service Credit Union today for more details about our home equity loan products. Learn more about all of PSCU’s home loan options. Call 260-432-3433 or start your application online.