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Are Equity Loans A Good Idea
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Reasons To Use Home Equity
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Home equity loans help homeowners leverage the value of their home to access cash easily and quickly. Borrowing against your equity is worth it if you’re confident you’ll be able to make the payments on time, and especially if you use the loan for improvements that will increase the value of your home.
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However, there are several risks if you fall behind on payments. Consider these risks, as well as lender terms, before deciding to take out a home equity loan.
While all loans come with some level of risk, home equity financing is tied to your home — and using it to repay the loan — which means you should approach them with extra caution.
There are two main types of loans that use your home equity as collateral: home equity loans and home equity lines of credit (HELOCs). Here’s what happens with both or one of them.
The stakes are higher when you use your home as collateral for the loan. Unlike defaulting on a credit card — which carries penalties like late fees and a low credit score — defaulting on a home equity loan or HELOC means you could lose your home.
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Before you take out a home equity loan, do your homework. Ask yourself if you have enough income to make regular payments, if your income changes, and if home equity loans are the best solution for your financial needs.
After two years of steadily rising home prices amid the pandemic and a limited inventory of homes for sale, the real estate market has finally started to moderate and cool. The high cost of borrowing and high monthly mortgage payments dampened buyer enthusiasm. As a result, house price growth has stagnated and fallen in some places.
If your home’s value falls, you’ll owe more on the mortgage and home equity debt than your home is worth — a situation called negative equity. If you’re underwater or upside down, this can be a real problem, especially if you’re trying to sell your home.
If you have a HELOC and the value of your home drops dramatically, your lender may limit your balance — that is, reduce the amount of home equity you can borrow. And if your home is underwater, your HELOC is frozen and you can no longer withdraw funds.
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While loan terms vary by lender and product, HELOCs typically have adjustable rates, meaning payments increase as interest rates rise.
“The interest rate on a home equity line of credit is often tied to the prime rate, which increases if the Fed raises rates to cool inflation or an overheated economy,” says Matt Hackett, operations manager at mortgage lender Equity. Now.
Because interest rates are unpredictable, HELOC borrowers can end up paying much more than they originally signed up for — especially if rates rise quickly, as they did in 2022. In the worst cases, your monthly payments can become unaffordable.
On the other hand, home equity loans typically have fixed interest rates for the life of the loan, so you know what your monthly payment will be for the entire loan term.
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While you can usually repay the loan anytime you borrow, most HELOCs require interest-only payments for the first 10 years or their draw period (when you’re allowed to access the funds). If you only make these minimum payments, you won’t make any progress toward paying off your outstanding balance.
After the draw period ends, borrowers enter the HELOC’s repayment period: they begin repaying both principal and interest and can no longer use the line of credit. If you take out a large loan during the draw period and make only the minimum payments, you may experience sticker shock after the principal balance is added to your monthly bill.
Opening a home equity loan can also affect your credit score. Your credit score is made up of several factors, including how much of your available credit you’re using.
Adding a large home equity loan to your credit report can negatively impact your credit score. This makes it difficult to qualify for other loans in the immediate future. For example, if you get a home equity loan before you buy a car, it could mean getting a worse deal on your auto loan.
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In the long run, having a home equity loan and making regular monthly payments on it is likely to help your credit. Be aware of any short-term drops you may see.
This is because home equity loans use your home as collateral
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