What is HEL?
Published on: January 4, 2025
What is Home Equity Loan (HEL)—Everything You Need to Know
HEL, or home equity loan, is one of the most commonly used financing methods in the US. However, it is one of those loan types where you have to pledge something as collateral. So, is it a good option? What are the drawbacks and perks of home equity loans, and what should you consider? Let’s find out in this detailed guide.
What is HEL (Home Equity Loan)?
A home equity loan is a type of loan where you borrow money using the value of your home as collateral. The loan is based on the equity in your home. Equity is the difference between your home’s value and what you still owe on your mortgage.
HEL allows you to borrow a specific amount of money, depending on how much equity you have. The loan comes with a fixed interest rate. You have to repay the loan in monthly payments, just like a regular mortgage. The repayment period can be as long as 15, 20, or even 30 years.
How Does Home Equity Loan Work?
A home equity loan is like a second mortgage, where the lender uses your home’s equity as collateral. The amount you can borrow depends on the home’s value and the loan-to-value ratio, which is usually between 80% and 90%. Your credit score and payment history also influence the loan amount and interest rate.
These loans have fixed repayment terms, just like regular mortgages. You make consistent payments to cover both the principal and the interest. If you are unable to pay back, the lender has the right to sell your home to recover their money.
This loan can be helpful if you want to use your home’s value for things like renovations that could increase its worth. However, keep in mind that if home values fall, you might owe more than your home is worth.
Special Considerations for Home Equity Loans
Home equity loans have benefits and drawbacks of their own but it is important to consider these factors before opting for this option.
1. Changes in Tax Deductions
Home equity loans became popular after the Tax Reform Act of 1986 because they allowed people to avoid losing tax deductions for interest on consumer loans.
However, the Tax Cuts and Jobs Act of 2017 suspended these deductions until 2026, except for cases where the loan is used to build, purchase, or improve the home.
For example, if you use the loan to pay off debt or for college costs, the interest is no longer tax deductible.
2. Planning and Estimating
It is important to know your finances before you apply for home equity loans. You should have a clear idea of your credit score and home value. Be aware of appraisal costs because if the appraisal is too low, you may not qualify, and you will not get a refund.
3. Debt Consolidation Considerations
If you intend to use HEL to consolidate your debts, check with your bank to ensure the new loan’s monthly payments are lower than your current debt payments. Yes, these loans may have lower interest rates, but they often have longer repayment terms, which may result in paying more over time.
Benefits of Home Equity Loans
Home equity loan is beneficial in different ways, such as.
More Predictable Interest Rates
HELs have a fixed interest rate for the entire loan term. This means your interest rate will not change, even if market rates fluctuate. You will know exactly how much you are going to pay throughout the life of the loan.
Reduced Interest Rates
The interest rate is generally lower as compared to personal loans or credit cards. Although there may be some closing costs, the interest is generally much lower. That is because the loan is secured by your home, which minimizes the risk for lenders and allows them to offer better rates.
Longer Repayment Periods
Home equity loans often have long repayment terms (up to 30 years). As the interest rate is already lower, this can make monthly payments more affordable.
Tax Benefits
If you use the loan for home improvements, the interest may be tax-deductible. This helps you save money on your taxes.
More Borrowing Potential
Thanks to home equity loans, you can also borrow more money based on the equity in your home. This makes it a good option for funding major expenses like home improvements or paying off high-interest debt.
Drawbacks of Home Equity Loans
Here is the unwanted side of home equity loans.
Risk of Losing Your Home
A home equity loan uses your house as collateral, which means your home is at risk if you cannot repay the loan. Unexpected events could make it harder to repay. If you fail to make payments, the lender may take your home.
Equity Requirements
You usually need to have at least 20% equity in your home for loan qualification (some lenders may accept 15%). This means you should own at least 20% of the home outright. If you recently bought your home with a small down payment, you might need to wait until you have enough equity to apply.
Home Value Fluctuations
It is possible that the value of your home goes down over time. If the real estate market drops, you may end up owing more than your home is worth. This situation is called being “underwater” on your mortgage.
Closing Costs
Home equity loans often come with closing costs. It can be 2%-5% of the loan amount. These charges can make the loan more expensive.
Summing it up
Home equity loans may be a good option to finance a home renovation or pay for other major expenses, but they have some drawbacks that you must consider before opting for HEL. Apart from that, there are certain types of fees attached to home equity loans.
For example, you can expect to pay an origination fee, which may vary based on one lender and loan amount. You may have to bear the following expenses as well.
· An appraisal fee typically costs between $300 and $800.
· credit report fee that can range between $10 to $100.
· Document or filing fees, which are usually around $125.
· Title fees for a title search range from $75 to $450.