Home equity loans are ubiquitous with low interest rates, easy to access cash, and fantastic tax advantages. Scoring a low interest rate home equity loan in the current environment, though, might set you back some time, money, and frustration.
It is true that home equity loans are low cost, which is one of the many reasons they’re a go-to source for easy to borrow capital. However, getting a home equity loan post-financial crisis and real estate meltdown of 2007-2009 isn’t so easy. Banks have upped the ante, and new regulations may stop borrowers from taking money out of their home.
Getting a Home Equity Loan
Getting a home equity loan at a low interest rate requires that you own your own home, and have built up substantial equity in the home. Equity, of course, is the amount of the difference between any debts against the home and the current value of the home. If you currently own a home worth $350,000 and have a $140,000 loan against the property, then you have home equity of $210,000, or 60% of the property value. In such a case, you would be a great candidate for a home equity loan.
Banks operate on a loan-to-value basis, normally selecting “80 percent” as the right target for a home equity loan, or any loan, for that matter. The concept is fairly simple, the bank will recognize 80 percent of the home’s equity, and offer a loan based on that amount. Thus, if you own a $100,000 home outright, then the bank will loan you up to $80,000 against its value.
If, however, you own $40,000 of a $100,000 home, then the bank will take 20% from $100,000 to arrive at $80,000. From there, you own only $20,000 of that $80,000, since the 20% off the top comes right out of your home ownership. The bank, then, will lend only $20,000 against your property.
Relationship between LTV and Rates
There is a very distinct relationship between the loan-to-value and the interest rates you get on any new loan. Since any home equity loan is secured by the ownership of a piece of property, the risk is two-fold: your ability to pay, and the future of real estate prices.
If real estate prices fall, then it is possible that the bank holds a portion of the home equity that is worth less than the current loan balance. If you fail to pay, well, then the bank has to worry about your home’s value.
In reality, your income and numbers come first; banks aren’t in the business of buying and selling homes for a profit and would prefer that their borrowers pay them back on time, and in full. However, even while banks hardly find an interest in foreclosing on properties, they do have additional willingness to make very small loans against very sizeable amounts of home equity.
A homeowner who owns a $100,000 home without a mortgage would find it easy, almost too easy, to borrow $20,000 against the value of the home. Should the borrower repay the loan, then the bank makes money. If the borrower defaults, then the bank forecloses on the home and gets its money back, anyway.
Be Careful with Home Loans
There is a natural tendency to use home equity loans to pay for virtually everything. A home equity loan allows for tax deductibility against income for every dollar of interest over the IRS’s annual standard deduction. Therefore, paying 6% interest at a 33% tax rate means that a borrower really pays only 4% annual interest after realizing a 33% tax savings.
Even low interest home equity loans aren’t necessarily safe. The additional risk in losing homeownership should give borrowers second thoughts about their ability to finance the loan, and how they want to borrow money. There is no shortage of people who, during the worst of the housing downturn, lost their source of income and ultimately their home to a second or third mortgage. The tax savings, then, were only a small piece of the picture, and had they borrowed elsewhere, they would still own their home.
For those confident enough, a home equity loan can make a lot of sense, but always be sure to consider the worst case scenario and whether the low interest rate offered on a home equity loan is worth risking your home.