Let's say you need to borrow money, and it’s more of choice between putting $500 more on your credit card or going without it. Might a home equity loan be a good solution?
Home equity loans drew a lot of attention late last year when President Donald Trump signed the Tax Cuts and Jobs Act of 2017. The legislation suspended the tax deduction for interest paid on home equity loans and home equity lines of credit, starting in the tax year 2018 and running until 2026. A taxpayer can still use the deduction only if the loan is used to buy, build or substantially improve the home that secures the loan.
"Home equity remains cheaper than personal loans and credit cards (with an average rate of 14.89 percent), and can be a very smart way to pay off that debt," he told Forbes. "Just be warned: After the financial crisis, lenders tightened approval criteria for home equity products.”
To get a sense of whether a home equity loan is something that might work for your situation, Clements and other lending experts provided the necessary background for prospective home equity borrowers working in the post-Tax Cuts and Jobs Act of 2017 lending market:
What is a home equity loan, exactly?
This type of loan is money you borrow against the difference between the amount you owe on your home and the home's market value, according to Lending Tree. The lender pays you a lump sum that you pay back at a fixed interest rate with fixed monthly payments.
The money from a home equity loan (HEL) can pay for home improvements, medical bills, college tuition or even a vacation. "The money can be used for anything, but if you're using the value of your home to pay for frivolous expenses, you may want to think twice," Lending Tree noted.
What are the "must haves" for someone trying to get a home equity loan?
In order to qualify for a home equity loan in 2018, you'll need these things, according to Lending Tree:
- Equity in your home. And note that your lender won't let you borrow every dollar of that equity. Banks use loan-to-value (LTV) ratio to help determine exactly how much you can borrow, and each one has different requirements.
- Loan-to-value ratio. Banks calculate LTV by adding the amount you want to borrow with a home equity loan to the amount you owe on the home, divided by the market value of the home. Below 80 percent is a good LTV to assure eligibility, according to Lending Tree, but some banks allow for a higher LTV.
- Income. You must show you make sufficient income to cover the cost of your current debts, plus the added debt of the HEL. A low debt-to-income ratio is important, too.
- Credit history. The lender will assess the type of credit accounts you have, the balance on those accounts, and how long they've been open. They'll also look at your payment history and whether you have any late payments or collections on your account.
- Ability to repay. Lenders are required to put forth a good faith effort to determine if you have the income, assets, employment and so forth to be able to repay your loan.
How do the interest rates compare to other credit?
"Because these loans are secured by real estate, interest rates are much lower than unsecured personal loans or credit cards," Clements noted. "Many home equity line of credit products offer rates near or below 5 percent. Personal loan interest rates typically start above 5 percent and can go much higher."
Does losing the tax deduction devalue the home equity loan? The former ability to get a deduction on a home equity loan made them even cheaper, but in some instances, you can still take the deduction and in many others, it doesn't really matter, Kim Paskal, CPA and tax shareholder at BeichFleischman told the Lending Tree blog. "Because of the rise of the standard deduction up to $24,000 for [taxpayers who are] married filing jointly, not only are most people not going to take the HEL deduction, but you probably don't even care if you get your mortgage interest deduction."
How do changes in personal loan interest rates affect your decision?
"For people with excellent credit, it is now relatively easy to take out a personal loan with a low single-digit interest rate and no origination fee," Clements noted. Paying an extra 1 percent or 2 percent on the personal loan rate instead of risking your home as collateral for a HEL might be worthwhile, he added. Personal loans also tend to be a quicker source of money for emergencies and have shorter terms, which force you to pay back more quickly and will build your net worth over time, he added.
Where do you find a reputable home equity lender?
If you're sold on a home equity loan, or at least on the idea of further exploration, be sure to distinguish between a reputable lender and the first to pop up with an ad on your home screen. The best home equity loan lenders have an efficient application process, explain loan options clearly and tailor their services to the varying needs of individual borrowers, according to NerdWallet in its objective and independent coverage of "Best Home Equity Loan Lenders."
Do you really want to borrow at all?
Clements cautioned people considering home equity or any other sort of borrowing. "A home equity loan can be an excellent way to finance home improvements that lead to property price appreciation," he wrote in Forbes. "It can be a rational way to deal with a big emergency. However, it should not be a convenient way to live beyond your means: with or without the tax deduction."