A home equity loan, also known as a second mortgage, is a loan that allows homeowners to borrow money against the equity of their homes. It is provided by banks and financial institutions on the basis of any appreciation in the market value of the house you own.
You can avail of this type of loan even if you have an outstanding home loan. It is calculated on the basis of the difference between the current value of your house and your remaining mortgage balance. So, in order to arrive at the final loan amount in these cases, the lender assesses the current market value of your property and deducts the outstanding loan amount.
Usually, homeowners get around 50-60 percent of the total market value of their properties as the eligible loan amount. You can use this loan in case of emergencies or to renovate your house etc. The loan is paid out in lump sum and you have to pay it back in installments depending on the tenure you opt for.
However, one must note that it is called a second mortgage since the loan is secured by your home, and in case you are not able to repay your loan, the bank or financial institution has the power to foreclose it which means you can lose your existing home.
In case of foreclosure due to the inability to pay your home loan, you have to clear the home loan first before moving on to pay the home equity loan.
Eligibility criteria
For this type of loan to work, the first and foremost eligibility is that you must have a house to take the loan against. Other than that it works like any other loan. The banks or financial institutions check your ability to pay back the loan via your bank and salary statements.
Apart from that, lenders also examine your credit score and reports to check if you have any other debts like unpaid credit card bills, other loans, etc. These will also be used to determine the rate of interest at which you will get the loan. The better your credit history, the lower the interest rate you can negotiate.
After the loan is sanctioned, an EMI (equated monthly installments) is decided upon based on the tenure you opt for and the interest rate provided by the bank.
Let's now look at the advantages and disadvantages of such loans:
Advantages
Lower and fixed rates: Since these loans are backed by collateral (your house), you can bargain for lower rates as compared to personal loans, credit cards, or home loans. Also, the interest rates decided at the beginning are fixed, so the amount you have to pay monthly will not be dependent on any external factors. Even if interest rates rise, your home equity loan rate will not be impacted.
Long repayment terms: Unlike personal loans, you can choose a longer tenure to repay your home equity loans like 20 or 30 years. This coupled with lower interest rates can make the EMIs very affordable.
Flexibility: You receive a lump sum after availing of these loans which can be used for many purposes. It does not have to be house-related. You can use it to start a business, renovate your home, pay back other debts, for investment purposes, medical emergencies, etc.
Tax benefits: Such loans also provide tax benefits. You can use them to lower your total taxable income. The interest on the loan can be deducted if it is used to buy new property or renovate any old ones.
Drawbacks
Risk: The biggest drawback of this type of loan is that you can lose your house if you do not pay back the loan. In case of any defaults in payments, the lender has the right to take possession of your property since it is used as collateral to get the loan. Another risk is that if the value of your property decreases, it may become difficult to sell on a profit margin.
Credit score: You must have an excellent credit score in order to get this type of loan otherwise it can be denied. Also, your interest rates may rise, if you have higher debt.
Higher costs: These types of loans have higher bank fees and closing costs. Before availing of the loans, it is important to compare the rates and fees among different financial institutions and banks before choosing one.
Two mortgages: If you already have a home loan, you will be juggling to pay 2 EMIs every month which reduces your spending power as well as savings.
Let's now look at the advantages and disadvantages of such loans:
Advantages
Lower and fixed rates: Since these loans are backed by collateral (your house), you can bargain for lower rates as compared to personal loans, credit cards, or home loans. Also, the interest rates decided at the beginning are fixed, so the amount you have to pay monthly will not be dependent on any external factors. Even if interest rates rise, your home equity loan rate will not be impacted.
Long repayment terms: Unlike personal loans, you can choose a longer tenure to repay your home equity loans like 20 or 30 years. This coupled with lower interest rates can make the EMIs very affordable.
Flexibility: You receive a lump sum after availing of these loans which can be used for many purposes. It does not have to be house-related. You can use it to start a business, renovate your home, pay back other debts, for investment purposes, medical emergencies, etc.
Tax benefits: Such loans also provide tax benefits. You can use them to lower your total taxable income. The interest on the loan can be deducted if it is used to buy new property or renovate any old ones.
Drawbacks
Risk: The biggest drawback of this type of loan is that you can lose your house if you do not pay back the loan. In case of any defaults in payments, the lender has the right to take possession of your property since it is used as collateral to get the loan. Another risk is that if the value of your property decreases, it may become difficult to sell on a profit margin.
Credit score: You must have an excellent credit score in order to get this type of loan otherwise it can be denied. Also, your interest rates may rise, if you have higher debt.
Higher costs: These types of loans have higher bank fees and closing costs. Before availing of the loans, it is important to compare the rates and fees among different financial institutions and banks before choosing one.
Two mortgages: If you already have a home loan, you will be juggling to pay 2 EMIs every month which reduces your spending power as well as savings.
What should borrowers do?
While such loans do have benefits over personal loans or credit cards, they should be availed only in case of emergencies. Also, you must note that you should have sufficient monthly income to pay both the EMIs (in case you have a home loan as well).
Since your house is collateral, the interest rates and processing fees may be lower when compared to a personal loan but this also adds the risk of you losing your home in case of defaults in payments.
So when you are looking to avail of home equity loans, you should always compare rates and fees amongst banks and other financial institutions and should only use it in case of an emergency.