“When should I get a home equity loan?” is a common question in today’s housing market.
Whether you want to remodel your kitchen or pay off those student loans, you’ve probably at least thought about a home equity loan.
It’s a low interest loan that comes from the equity you have in your house. It comes in a lump sum so you get the money all at once.
Although we do think home equity loans are pretty great (see our post here about them being the best loans), there are a few things to consider first. Here are some questions to ask before taking one out:
Do I have enough equity to qualify for a home equity loan?
Before you can get a home equity loan, most banks and credit unions require you to have at least 15% – 20% equity in your home already. These unique loans are based on 80% of the market value of your home minus the principal of the mortgage. In other words, if your current home is worth $500,000 and you have a $400,000 mortgage (20% equity), you will be able to borrow up to $15,000.
The more you have paid down on your home or the more your home’s value has increased, the more you will be able to borrow. This means that although you may be able to get a home equity loan shortly after purchasing a home, you will be able to borrow more if you wait. For example, if you have the same home as above, but have 30% equity, you will be able to borrow up to $75,000.
Will I use the home equity loan to add value?
These loans have few technical restrictions. This means that, in theory, you can spend the loan on whatever you want, regardless of whether or not it adds long term value. However, you can miss out on major opportunities for financial growth if you don’t think about why you are taking out the loan in the first place.
A good rule of thumb is to use the loan on something that adds value. A home remodel adds immediate value to your home. So not only do you get the benefit of living in remodeled spaces, your house will likely be worth more than it was when you bought it.
Here are a few other value adding things to spend a home equity loan on:
- Home renovations
- Paying down large sums of debt (home equity loans have a much lower rate than credit cards or loans)
- Paying for college (as long as the home equity loan rate is lower than the student loan rate)
- An investment property (this is riskier, since not all investment properties make money, but this can be a great way to diversify investments in real estate)
Here are a few things that don’t add value and therefore are not good candidates for a home equity loan:
- Buying a car
- Repairs (although sometimes a home equity loan can still be a good option compared to other borrowing options)
- Non-value adding renovations
Can I afford the monthly payments?
Although the fixed rate payment on these loans is fairly low compared to the amount you can borrow, it is still an additional payment you need to make on a monthly basis. Before applying, be sure to count the monthly addition into your budget.
Am I comfortable with the risk?
These loans are low interest, fixed rate loans with a long pay off period, which means the payments are often low, predictable and affordable. However, you are using your home as collateral on the loan, so if you default, the risks are higher.
People have different levels of comfort when it comes to financial risk. It is always better to be honest about the risk level and whether or not you are comfortable with that risk before making such a big decision.
If you are interested in a home equity loan, start applying here.