If you are in need of some extra cash, you may be considering a home equity loan. In this tight lending environment, however, it’s more important than ever to make wise borrowing decisions. A home equity loan may be right for some, but for others it can be inadvisable.
Here are some questions you should ask yourself before you apply for a home equity loan:
What am I going to use this for?
Pulling equity out of your home to pay for unnecessary spending like travel or consumer goods is almost always a bad idea. Equity in your home is an investment. Pulling equity out of your home to pay for a vacation is like taking money out of your 401(k). The best uses for a home equity loan are towards expenses that could be seen as investments. For example, using home equity to finance renovations on your home is wise because the renovations will likely increase its value. Other good uses for a home equity loan include paying for college education, paying off high-interest debt and investing in another property.
Can I qualify?
Getting a new home equity loan in the middle of the housing crisis is tough. Many lenders are wary of approving second mortgages because of falling home prices. It’s still possible to open a new home equity loan, but you need to have a lot of equity in your home. In general, your loan-to-value ratio needs to be less than 80% after you receive the loan. In some cases, lenders may want you to have even more remaining equity.
Can I guarantee repayment?
Tapping into your home equity is a risky business because it puts your home on the line. If you are unable to or fall behind on your payments, the lender can foreclose on your home. Even if the home equity loan is for 10% of the home’s value, the lender can execute a foreclosure to recover their money if you become delinquent. Before you take out a home equity loan, make sure your employment is stable, your income steady and you have room in your budget for payments.
Am I reloading?
Taking out a home equity loan to consolidate high-interest debt is a good idea because you will be able to pay less interest and save money. If your debt is a result of over-spending and you don’t change your spending habits, however, you could end up just “making room” for more debt elsewhere. Also known as "reloading," this is a dangerous cycle that can lead towards foreclosure or even bankruptcy.
Will I need to refinance in the near future?
Having a second mortgage when you try to refinance can complicate the process. Some lenders will not allow you to refinance a primary mortgage until you have paid off the second mortgage. If they do, some home equity lenders will not agree to be subordinate to the new primary mortgage, which can prevent the refinancing from going through. If you plan on refinancing before you pay off your home equity loan, wait to take out the home equity loan until after the refinance is complete. Or, consider a cash-out refinance to kill two birds with one stone.
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