Home equity loans — Top do's and don'ts

What is a home equity loan?

A home equity loan (sometimes called a “second mortgage”) enables you to borrow money based on how much your home is currently worth compared to how much you still owe on your mortgage principal.

Here’s how it works: Let’s say you buy a $200,000 home with a 20% down payment with a $160,000 mortgage loan. That means your initial equity in the home is $40,000. If, over the next two years, your regular mortgage payments reduce your mortgage principal by $10,000, you would have $50,000 in home equity that you could potentially borrow against after just 24 months.

Thinking about a home equity loan? Let’s answer a few scenarios.

  • Do you find yourself in need of additional financial resources?
  • Does your growing family need more housing space?
  • Are debts accumulating faster than you can keep pace?
  • Do you have a high school student looking at a college education—but with no way to pay for it?

To help fund needs like these, you may want to consider a home equity loan. How do you know if your home has enough equity? Here are a few questions to ask yourself.

  • Have you lived in your home for more than a few years?
  • Have you consistently paid down your mortgage principal?
  • Are property values increasing in your area?
  • Have you made any substantial improvements to your home?

If you can answer “yes” to any of these questions, then your home’s value has probably increased since you moved in. The difference between what you still owe on your mortgage principal and what your home is currently worth is called “equity,”—and it’s a resource you may be able to use to your financial advantage. Here is what you need to know.

Do pay attention to property values

The value of homes is constantly changing. According to Zillow, the average home nationwide is currently worth around $287,000. Zillow expects home values to rise by another 14.9% within the following year. If property values increase in your area, you could see more equity coming your way soon.

Don’t forget to monitor your credit score

Mortgage lenders look at your credit score and your current debt load when deciding what interest rate to offer you. To help get a lower rate, try paying off overdue bills or maxed-out credit cards. Resolving these issues before applying for a home equity loan may help you get a lower interest rate.

Don’t use your home’s equity to buy frivolous things

Use your home’s equity responsibly. Don’t use your home equity to fund your next big vacation or buy the luxury car you have always wanted. Remember, any brief moments of happiness you gain from a frivolous purchase are not worth risking your home’s long-term financial security.

Do renovate

Have you ever wanted to update your space? There are more benefits than you might think! Updating your kitchen or replacing your garage door for curb appeal will not only add comfort and convenience to your house but add equity as well.

Do understand the differences between a Home equity loan vs. HELOC

A home equity line of credit (HELOC) is like the credit card of home equity. You establish it in advance and use it when you need it. A HELOC has a credit limit and a specified borrowing period (usually ten years). During the ten-year period, you withdraw money periodically when needed, and you pay interest on the money you use. After the borrowing period is finished, there is a repayment period where you pay off your remaining balance and interest. The repayment period usually lasts around 10-20 years.

A home equity loan is like a second mortgage on your house. With a home equity loan, you borrow a specified amount. The interest rate usually is fixed, unlike a HELOC.

Do remember the pros

Whether interest rates are falling or rising, you have a fixed interest rate on a home equity loan. This loan uses your home as collateral, and the interest is often much lower than the rate on a credit card or personal loan.

Don’t ignore the cons

It’s crucial to keep in mind those final details before getting a home equity loan.

  1. If you’re still paying on your first mortgage, you’ll need to be able to handle a mortgage payment for each loan.
  2. If you stop making payments on your loan, you could lose your home to foreclosure.
  3. There are fees and closing costs to close on a home equity loan. They could range from 2% - 5% of the loan amount.

No matter your decision, home equity can be a positive investment when used in the right way. Make sure you are knowledgeable in the do’s and don’ts of adding on a second mortgage to your home.