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Monday 11/20/2017 Mortgage Rates

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Home-Equity Loans

A home-equity loan is where the homeowner exchanges their home equity as security levelled against their home. The amount of the loan depends on the property's appraised value (an appraiser is often provided by the lender). The difference between the current outstanding balance of the mortgage and the appraised value of the home will be the home equity and, thus, the amount of the home-equity loan. 

The home-equity loan term can be five to fifteen years long. It is paid off monthly at a fixed rate of interest for the entire duration of the loan term. It differs from the original mortgage in that you are given the lump-sum of cash in hand, rather than being directly allocated towards the outstanding balance.

Home-equity loans shouldn't be confused with home equity lines of credit (HELOC). To learn the differences between the two, click here.

Home-equity loans are most appropriately used for:

  • Major home repairs
  • Major home renovations and remodels
  • Weddings
  • Large investments
  • Paying off credit card debt
  • Emergency medical bills

The reason home-equity loans are used rarely is due to the loan being in the form of a lump-sum.

A Remedy for Irresponsible Spenders

The home equity is immediately reduced when the borrower uses this type of loan. What distinguishes it from other home equity-related loans is that it is a one-time-only transaction, limiting borrowers that lack discipline from driving themselves into deeper and deeper debt. Don't spend your home equity on anything fleeting as this may cause you to foreclose on your mortgage and risk losing everything you've built over the years.

Home-Equity Loans and CLTV

The appraised value of the home and the size of the original mortgage are what determine how much equity the borrower can tap into. This is found by using the loan-to-value formula:original mortgage amount ÷ appraised home value = loan-to-value. The result is how much equity the borrower has that's convertible to cash, or usable to finance the outstanding balance on their existing mortgage.

Since using a home-equity loan effectively means activating a second mortgage, the remaining combined loan-to-value needs to be reasonable - 80% or less is ideal for most lenders. The combined loan-to-value formula is found by adding the original mortgage with the second mortgage, followed by dividing the result by the total appraised home value:[first mortgage + second mortgage (the home-equity loan)] ÷ total appraised home value = combined loan-to-value ratio

Example: 

Outstanding balance of the first mortgage: $180,000
Home-equity loan (second mortgage): $40,000
Appraised home value: $300,000

We simply add the mortgages together and divide the result by the appraised home value to get the combined loan-to-value ratio: (180,000 + 40,000) ÷ 300,000 = 73.3%. This is a good ratio as it is well under the maximum limit for high-risk borrowers. The lower this ratio is the more home equity and leveraging you have.

Requirements for home-equity loans:

  • Proof of income and employment.
  • Proof of tax returns.
  • Good amount of home equity.
  • A reasonable combined loan-to-value.
  • "Good" credit score (720 or higher).
  • Closing costs (3 - 6% of the loan amount).
  • The fees associated with the processing of the new loan, and appraisal of the property. Additional fees could be included but these are the most prevalent.

The Rates on a Home-Equity Loan

A home-equity loan is a fixed-rate mortgage, it allows you to plan and budget at your own pace. During times of high rates, you reap the benefits of not incurring additional charges. You know exactly what your payments are going to be 5, 10, or 15 years down the line.

Shouldn't I Just Use My Credit Card?

Both home-equity loans and home equity lines of credit provide cash with far lower rates than those imposed on your credit card. Not to mention, home-equity loans of up to $100,000 are tax deductible (although this could vary with different mortgagors).

The Disadvantages of Home-Equity Loans

The important thing to remember with loans relating to home equity is that there are different types more compatible to different financial situations. Cash-out refinancing and home equity lines of credit (HELOC) are two important variants to these kinds of loans.

Here is a brief look at how home-equity loans could damage your credit:

  • One-time-only loan.
    Make sure that you spend this loan on something important because you won't get another one when you need it most.
     
  • Fixed interest rates are typical of home-equity loans.
    Your monthly payments remain unchanged even when rates drop for everybody else.
     
  • Closing costs.
    Unlike home equity lines of credit (HELOC), home-equity loans require closing costs between 3 - 6% of the entire loan amount.
     
  • A second mortgage to consider.
    You have two mortgages looming over your head now, you need to have more discipline with how you manage your finances and give more time to building more home equity.
     
  • Home-equity loans are "closed-ended".
    What does this mean? It means that it's not a revolving account like an HELOC. If you've used it once, you can't use it again, and this may compel you to take a larger loan than what you need and risk foreclosure.

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