We hear the commercials on the radio promoting home equity loans, but do you really know what they are? In this article, let's take a look at what is a home equity loan and how does it work?
A home equity loan is a loan offered by a bank or finance company that will use the equity in your home as collateral. The bank or finance company provides you with a loan and registers a mortgage on the title to your home. Interest rates offered are lower than credit card rates but higher than first mortgage rates.
I think the best way to completely answer this question, "What is a Home Equity Loan and How Does It Work?"' is to look at some example situations and explore the home equity loan from a few angles.
I've talked to clients who have set up home equity loans and they shouldn't have. I've also talked to clients who were declined by their bank for a mortgage and should have applied for a home equity loan.
Each person's situation is different and a home equity loan may be the best solution for you but there may also be a better solution. Let's first review why you may want to apply for a home equity loan.
Why Would You Apply For A Home Equity Loan?
A home equity loan will involve some set up costs, so the decision to apply for this type of loan will There are 4 main reasons that you would consider applying for a home equity loan:
- You were not approved for a personal loan because the loan was too big
- You were not approved for a personal loan because they couldn't confirm your income
- You have bruised or bad credit
- You need the money fast
- You don't qualify for a traditional mortgage or HELOC
- You've heard the radio commercials or seen the TV Ads
You Were Not Approved For A Personal Loan Because The Loan Was Too Big
Most banks will provide you with a personal loan if your credit is good and they can document your income. If you apply for a loan for a larger amount, typically an amount over $50,000, the lender will want some collateral to protect them and the money that they are lending to you.
The first option most lenders look at is your vehicle (or vehicles). If you have a vehicle with adequate value and no financing attached, they could use your vehicle as collateral and provide you with a loan.
If you don't have a vehicle another way to reduce the risk is to reduce the amortization of your loan. Instead of provide you with a loan amortized over 5 years, they could reduce the amortization to 3 years or 2 years.
The loan with a short amortization has a lower risk than a loan with a longer amortization. However, a short amortization means a bigger payment.
They also factor the payment and affordability. The don't want to provide you with a loan you can't pay back.
If you own a home, then your home could be used as collateral for your loan and now it's a home equity loan instead of a personal loan. With a home equity loan, the bank can amortize the payments up to 25 or 30 years.
A home equity loan is a great option because the loan payments can be very affordable and they are using real estates as collateral.
You Weren't Approved For A Personal Loan Because They Couldn't Confirm Your Income
Traditional lenders like the big banks, credit unions and trust companies are fairly conservative lenders. They want to protect their shareholders investment. These lenders have specific methods to confirm your income.
These lenders will want to look at employment letters and pay stubs to confirm your income. If you are self employed, they want to see 2 years of income tax returns to confirm your income.
Some people generate income in different ways. If you have tenants in your home, or roommates who pay you monthly rent, then you are generating income from them. This helps you to cover your bills. A bank won't consider that unless you declare it on your income tax return, for 2 years.
The same goes for having an Airbnb. If you rent out a room or had a little Airbnb side business, banks want to see history of this income through income tax returns. If not, they won't approve you.
If you were recently self-employed and can't provide 2 years of income tax returns, then it's going to be tougher to get a loan.
If you generate income in a non-traditional way, then a bank or credit union may not provide you with a personal loan. The next option could be a home equity loan.
Most home equity loan lenders will use some common sense lending practices. If you say you are earning extra income some way, some how. They will ask you to show some proof. Provide a bank statement showing that you deposit $500 every 2 weeks, or a couple hundred a week, or what ever.
Home equity loan lenders will listen to your story and see if it makes sense. They will be using your home as collateral, so they have fairly good protection if you don't pay.
The way they gauge the risk is by calculating how much the total financing of your home is compared to the value of your home. This is called the loan-to-value ratio or LTV. The higher the LTV, the higher the risk. The higher the risk the higher the cost and the higher the interest rate.
You Have Bruised or Bad Credit
When your credit gets bumped and bruised, most banks will not take the risk to provide a personal loan. You will either have to improve your credit before you apply for a loan or visit a lender who charges higher rates.
There are lots of these lenders who will offer unsecured loans for clients with bad credit. To compensate for the bad credit, they offer higher interest rates. I've seen some rates over 36%. I can't think of too many reasons why you would need (or want) to pay 36% interest on a loan.
That's where a home equity loan could be a solution. If you own a home and have enough equity in your home, then you could get a home equity loan at a much lower interest rate. The loan could be set up over a longer time period to make the payments lower.
There are many different lenders offering different options and rates to clients who have bruised or bad credit.
If you are looking for this type of financing, it's best to speak with a mortgage broker. Your mortgage broker will have access to more lenders than you may have heard of. Some with much lower rates, some with higher rates.
Explore your options before you sign on the dotted line!
You Need Money Fast
One of the advantages of working with smaller companies that offer home equity loans is that they are fast. They are happy to move fast and provide you with the funds you need in a very short time frame.
Big banks, can take weeks to get things done. However, the speed of execution often comes at a cost.
If you qualify for financing with a big bank but you need the money in 2 days, they are not going to meet your request. A private lender could provide you the money that fast. A smaller, more nimble company would be happy to get you money in 2 days.
However, that speed will likely cost you 2 or 3 times more than if you could wait for the bank.
For a mortgage, a bank will usually take a minimum of 3 weeks to provide you with the funds. That 3 weeks is if everything goes well. If something happens along the way to delay things, then it's more likely a month before you can get the money.
Sometimes there are ways to speed up the process but that depends on your circumstances.
If you need the money fast, talk to a broker. Whether you speak with us, or another broker, that's up to you. Because I work with many different lenders every day, I often have solutions that clients may not consider or even know about themselves.
You Don't Qualify for a Traditional Mortgage or HELOC
Whenever you apply for financing and use your home as collateral, the best option for the financing is a first mortgage or Home Equity Line of Credit with an "A" lender . However, sometimes your "A" lender will turn you away. That is, they will decline your application. Then what?
An alternate lender could be your next option, however, I would recommend that you speak with a mortgage broker. Whether you speak with us, or someone else, a broker has a broader perspective. A broker will know what other "A" lenders offer and they will know alternate lenders as well.
I had a client who approached me who had been turned away by their bank. I was able to help them get a mortgage with another "A" lender and they didn't have to work with an alternative lender. Let's look at that example.
Example: Clients turned away by their current bank
Two clients were referred to me by a previous client. They had been turned down by their current bank. He had been laid off a year ago and has now been working for a year, but his income is half of what it was. She is self employed and lost her contract 6 months ago and was close to getting a new contract, but nothing finalized yet.
Over the last year, they had used up most of their savings. Their credit cards were close to the max and weren't sure if they could make the next mortgage payment coming up in 2 weeks.
We met and reviewed their financial situation. They needed to reduce their overall payments so that they could afford everything with his current income only. They had good credit and hadn't missed any payments yet.
With this information in hand, we found several "A" lenders who would help these clients if we structured their finances properly. That's what we did.
Within a week, we were able to secure an approval with one of the "A" lenders, complete the appraisal and send mortgage instructions to a lawyer to start the process of funding the new mortgage.
We refinanced the mortgage that they had with their current bank, paying it out. We also secured enough money to pay off all their credit card debt and a personal loan. We also secured an additional $20,000 to replenish their cash reserves (emergency fund).
The new mortgage rate was very close to the old rate (within a quarter of a percent) but their overall payments were reduced by $2,000 per month. They could now afford all their household expenses on his income only.
When she secured her new contract, then they can start paying more toward the mortgage and also continue to build up their savings.
A home equity loan was an option for these clients. They almost called one of those companies that advertises on the radio. Had they called, they would have been approved instantly.
However, they wouldn't have known about the option that we found for them.
One of the benefits of working with professionals, like members of my team, is that we help clients with some cash-flow planning. We offer this service so that clients can get ahead financially.
By reviewing cash-flow, we can help clients find and choose solutions that will benefit them now and long into the future. Connect with us to review your cash flow.
Now, let's talk a little about those companies that advertise on the radio...
You've Heard The Radio Commercials or Seen The TV Ads
Ok, I'm a little cheeky here. There are 2 companies, Alpine Credits and Capital Direct who advertise heavily in the home equity loan space. When I say their names, I can see and hear one of their ads or hear their jingle. Can you?
These companies are direct competitors and they have a similar offer to clients. If you call either of these companies, you will be working with a sales person who only offers loans from their company.
My caution to you is that you aren't necessarily receiving choices when you approach a lender directly instead of through a third party like a broker.
I had a client who heard the ads on the radio for years, like we all do. When something came up in his life, he contacted Alpine Credits. He was approved for a home equity loan and received his money within a week.
However, he would have qualified for a Home Equity Line of Credit and my lender, at that time, was covering all the set up fees. The HELOC would have taken 3 weeks to set up, but the cost of the HELOC was thousands more than he paid. He would also pay a penalty to pay off the home equity loan before the end of the term.
Understand your options and choices before you sign for the first offer you receive.
How Does A Home Equity Loan Work?
A home equity loan is a loan that is set up by a lender that uses your home as collateral. When a lender uses your home as collateral, they will register a mortgage against the title to secure their interest in your property. Once the loan is paid, then the mortgage can be discharged.
If you approach a bank for a home equity loan, then the maximum they can finance is up to 80% of the value of your home minus any mortgages already registered on title.
For example, Let's say your home is worth $500,000 and there is a mortgage with a balance of $300,000 already owing. 80% of $500,000 is $400,000. A bank could provide you with a home equity loan for up to $100,000 ($400,000 minus $300,000).
For a bank (or "A" lender) to provide you with financing, you must have good credit and enough income to afford the mortgage payments based on certain criteria. The "A" lender will typically offer rates than alternate and private lenders.
If your credit is bruised or you don't have income that is acceptable to an "A" lender, then you could apply for a home equity loan with an alternate lender or a private lender.
If you have been turned away by your bank (or an "A" lender), then it's better to deal with a mortgage broker. A broker will have access to many alternate lenders and understand who may be better for your specific situation.
You could approach an alternate lender yourself, but you will never know if there is a better deal with a different alternate lender or not.
Many alternate lenders will offer home equity loans when you have bruised credit. Many will also use some "common sense" when reviewing your sources of income. I've noticed that clients can be creative when it comes to making money.
They may rent a room in their home, or have an online business that generates some cash flow on the side. An alternate lender may include some or all of this income if it makes sense. An "A" lender will want 2 years of income tax returns to confirm that income.
For clients looking for a home equity loan, there are many different lenders offering different rates and options. You will typically get better rates the better your credit is. You will also get better rates the more equity remains in your home after the home equity loan.
Are Equity Loans a Good Idea?
Home equity loans can be a good idea if the loan is helping you to get into a better financial situation. It's best to review your finances with a professional to determine your options and evaluate whether a home equity loan is the best option.
If you can set up a personal loan to accomplish your goals, then a home equity loan may not be the best option for you. A personal loan can be set up with no fees whereas a home equity loan will have set up fees, legal fees and appraisal fees.
Let's look at a couple of examples.
Example: Personal Loan for $35,000 or Home Equity Loan
I recently spoke with a client who was looking for $35,000. The money was going to be used to complete some much needed renovations and repairs to their home.
Their home was worth $500,000. They had a mortgage balance of $300,000. They had credit card (and line of credit debt) totaling $30,000. He was laid off from work a year ago and was hired back as a contractor a few months after he was laid off.
These clients have good credit, but his bank would not accept his income. They wanted 2 years of income tax returns to use his income for qualification.
These clients didn't qualify with any other "A" lenders, but we were able to find a solution with an alternate lender. For these clients, it was better to set up the home equity loan for $75,000.
They paid off the credit card debt (reducing payments by $1,000 per month). They had good credit and received a good interest rate that was less than 3% above their current bank mortgage.
The extra $10,000 covered the legal fees, appraisal and set up fees and left a cash buffer in case the renovations cost a little more.
When their first mortgage comes up for renewal, he will have worked as a contractor long enough to qualify with an "A" lender. They will be in a position to restructure the 2 mortgages (that is, the first mortgage and the home equity loan) into one mortgage with one payment.
This home equity loan will help these clients to get set up financially, complete the repairs they need and improve their cash-flow.
How Do You Pay Back A Home Equity Loan?
A home equity loan will be set up with regular monthly payments. The payments can be principle and interest payments or interest only payments. With interest only payments, you aren't paying down the mortgage principle at all.
To pay back a home equity loan you have 3 choices, you can:
- Sell your home and pay off all the mortgages registered on title including the home equity loan
- Make additional lump sum payments toward your home equity loan over time until it's paid off
- Refinance your home and pay off the home equity loan with a new mortgage
Most home equity loans are set up with interest rates higher than the best rates available in the market. If you have a home equity loan and you don't have the cash to pay if off right away, then you will want to convert to a mortgage with an "A" lender when you qualify.
If you don't qualify with an "A" lender, then the next best thing is to look at all of your payments and create a plan to pay down your debt faster. One of the best methods is the waterfall method.
Many clients think that paying off the highest interest rate debt first is the best option. In fact, the best strategy is to pay off the lowest balance first. Direct additional funds to the lowest balance debt until it's paid in full and make minimum payments on everything else.
Once that is paid, direct all the funds that you were using to pay the lowest balance and direct those funds to the next lowest balance debt. This has an acceleration effect. More and more money is getting directed to your smallest balance debt over time.
Your smallest balance debt is paid, then the next smallest, then the next and before you know it all your debt is paid. I've seen clients use this method to pay off debt in a little as 18 months, compared to 60 months with a consolidation loan.
Is it Better To Get A Home Equity Loan or Refinance?
It could be better to set up a home equity loan instead of a refinance if you are in a better financial situation after. Sometimes, a refinance will involve a penalty. You want to evaluate and compare the penalty and refinance costs to the home equity loan set up costs and higher interest costs.
When you refinance your home, you are breaking the contract with your first mortgage provider to set up a new mortgage. Sometimes, the penalty to break the contract can be quite large.
When you set up a home equity loan, you don't have to pay the mortgage penalty, but there are set up fees (lender and broker fees) and the interest rate could be 3% or more higher than a comparable refinance rate.
To determine which one is best, you must evaluate the costs and balances over time. Let's look at an example.
Example: $500,000 Home, current mortgage $250,000 & $100,000 additional cash needed
These clients own their home renewed their mortgage last year. The interest rates today are similar to the interest rates from last year. They set up their mortgage with one of Canada's big 5 banks and the penalty to get out of this mortgage is almost $18,000. There is 42 months left in the term.
I wrote an article about how different lenders charge penalties, you can read about how different banks calculate mortgage penalties here.
For a home equity loan, the clients will pay legal fees and appraisal fees to set it up (which would be the same for a refinance, so I won't include this in the comparison).
Compare set up cost to penalty: They would be charged $3,000 for set up fees (lender and broker fees). For this part, $3,000 is much lower than the $15,000 penalty.
Compare interest rate for refinance vs. home equity loan: The rate offered is approximately 3% higher than the rate they would have received for a mortgage refinance.
Compare monthly payments for refinance vs. home equity loan: The overall payments would also be higher for the home equity loan. The difference is $380 per month and over the next 42 months.
That means the home equity loan will cost $15,960 more over 42 months.
Compare the end of term balance for the refinance vs. home equity loan: If the client added the penalty to the mortgage his new mortgage would start at $365,000 and after 42 months, the balance would be $327,800.
The home equity loan would start at $103,000 (he included the $3,000 set up fee) and after 42 months, the balance would be $95,990. He would have continued to make payments on his existing mortgage. Starting at $250,000, that mortgage would be paid down to $213,260.
The total balance for old mortgage plus home equity loan is $309,250
Summary: To calculate the best option, let's review add up the numbers.
The refinance. After 42 months, he would owe $327,800 on his mortgage.
The home equity loan. After 42 months, he would owe $309,250 ($213,250 plus $95,990) but pay an additional $380/month ($15,960).
If we add the mortgage balance to the additional payments, then we can compare apples to apples. $309,250 plus $15,960 is $325,210.
By choosing the home equity loan option, his effective balance is $325,210 which is $2,590 lower than the mortgage refinance balance of $327,800.
In this example, he is slightly ahead (almost $2600) by setting up a home equity loan instead of paying the penalty and refinancing his existing mortgage.
Can You Get A Home Equity Loan With Bad Credit?
Yes, you can set up a home equity loan with bad credit. There are many alternate lenders and private lenders who will provide financing up to 80% or 85% of the value of your home when you have bumped, bruised or bad credit. The interest rate offered is often dependent on your credit score. A lower credit score will result in a higher mortgage rate.
If you have bad credit, speak with a mortgage broker to review your options. Whether you speak with our team or a different mortgage broker, you will have more choice than going to a lender directly yourself.