Home Equity Loan
home equity loan
What is a home equity loan?
A home equity loan (HEL) is a second mortgage that allows you to tap a portion of your home’s value in a lump-sum payment. Home equity loans usually have fixed interest rates and are available in terms of five to 15 years.
Buying a house is an investment, one that can open opportunities in numerous areas of your life. Not only does it become a home for you and your family, you can also borrow money against the property, creating financial flexibility for a wide range of goals.You can access that flexibility is through a home equity loan (HEL) or home equity line of credit (HELOC).
When you take out a home equity loan, you receive a lump sum that you repay at a fixed interest rate.
With a home equity line of credit, you’re approved to borrow a certain amount, but you don’t need to use it all right away.
If you’re approved for $100,000, you might borrow in increments of $15,000 or $20,000, depending on your needs. Unlike HELs, HELOCs typically come with adjustable interest rates, though there are variations in the product terms you’ll want to compare to ensure you’re getting the best deal for your circumstances.
Home Equity Loan Requirements
There are three key factors that impact your chances of being approved for a HEL or HELOC.
Decent credit. The first is your credit score. Because some lenders are more conservative than others, each will have different credit thresholds for approval.
“Getting a home equity is very similar to getting a mortgage,” Kelly Kockos, senior vice president in home equity product management at Wells Fargo, told MagnifyMoney. Borrowers will likely need at least fair to good credit to qualify for a home equity product, she says.
Substantial equity. The second element that needs to be in place is your available equity, which is determined by your existing mortgage balance and the total value of your home. If you’re approved for a loan or line of credit, the lender will decide how much of your equity you can borrow against. Depending how their products are structured, they may allow you to borrow up to 85% of your available equity. Most lenders won’t go above 85%, according to the Federal Trade Commission.
a good rule of thumb is to have a loan-to-value ratio that’s well below 80% before applying for a home equity product.He suggests that if a home is worth $100,000, a mortgage balance of $50,000 would be a healthy ratio for taking out a home equity loan or line of credit. Assuming a lender allows you to borrow up to 80% of your home value and that you meet all other criteria, you might be approved for up to $30,000 to use as you see fit.
Kapfidze says the percentage for which you’ll be approved depends on the lender’s criteria and the relationship you have with them. If you hold other assets with them, they may feel comfortable offering a higher loan or line of credit, he says. But regardless of where you apply, equity below 80% will provide enough of a gap between your remaining mortgage and your home’s value to borrow the money you need.
Low debt. Finally, lenders will take your debt-to-income ratio into account. As with other credit decisions, they’ll look at how much you pay each month on your mortgage, student loans, car payments and credit cards, Kockos says. Keeping these as low as possible will boost your chances of approval because a high debt-to-income ratio may raise red flags about your ability to manage another significant payment.
“If your debt is over 43% of your income, then it’s probably not a good thing for you to take on more debt,” Kockos said.
Why you might want a home equity loan
Common reasons to take out a home equity loan are:
- Make major improvements to your home.
- Consolidate high-interest rate credit cards.
- Pay for college or fund a startup.
- Buy a rental property.
Use a home equity loan calculator to see what you might qualify for
If you’re considering a home equity loan, a home equity loan calculator may give you an idea of how much you can borrow. You can typically access up to 85% of the value of your home, also known as your loan-to-value ratio (LTV). Some home equity lenders may approve you for a higher LTV, but it’s best to leave some equity in case home values fall or you need to sell your home.
Three pieces of information are needed to use a home equity loan calculator:
- An estimate of your home’s value. An online home value estimator can give you a ballpark idea of your home’s worth. However, home equity lenders usually require a home appraisal to get a precise figure.
- Your outstanding mortgage balance. You should be able to find this on your monthly mortgage statement, or try calling your current mortgage servicer.
- Your credit score. The credit score a lender uses depends on which credit bureau is selected (Equifax, TransUnion and Experian). The three bureaus partnered to create a scoring model called VantageScore, and you can check yours for free through LendingTree.
How to get the best equity loan rates
Whether you’re tapping home equity for a major home improvement or to pay for a college education, these five strategies may help you snag the best home equity loan rates.
- Boost your credit score. Pay your credit card balances off monthly, if possible, and don’t be late. You’ll need at least a 740 credit score for a home equity loan offer with the lowest rate.
- Pick a shorter term. You may be offered a lower rate for shorter home equity loan terms. A five-year, fixed-rate term will get you the lowest interest rate, as long as you can swing the higher payments.
- Watch your debt-to-income (DTI) ratio. A measure of your total debt divided by your gross income, your DTI ratio should be 43% or less to get the best HEL rates. Borrow less of your home’s value. The more equity you leave in your home, the better your home equity loan rate will be.
- Borrow less of your home’s value. The more equity you leave in your home, the better your home equity loan rate will be.
- Shop around with at least three to five lenders. Some lenders are more competitive than others. Research has shown that comparing home equity loan offers saves consumers thousands of dollars.
Look beyond the interest rate. The obvious comparison point when comparing HEL and HELOC offers is the interest rate. However, there are several other factors to consider as well. One is the fee — how much is the lender charging on top of your monthly interest payment? Another is whether there are rate caps in place to protect you against future interest rate spikes. Kockos recommends looking at annual and lifetime rate caps to determine which offers provide the best protection features throughout the life of the loan.
Compare flexibility. Kockos also suggests comparing product flexibility among HELOCs. Some lenders will offer lock and unlock features for their home equity lines of credit. This allows you to secure a portion of your spending at current interest rates but unlock it later if rates drop and you want to secure those instead. If your lender offers a lock and unlock option, be sure to ask how many times a year you’re allowed to use that feature so you’ll know how agile you can be based on rate volatility. Kockos notes that some lenders will offer promotions or discounts on fixed-rate home equity loans, so it’s worth inquiring about those as well.
Consider closing costs. Jorge Davila, vice president of sales, consumer direct and digital mortgage lending at Flagstar Bank, says it’s important to compare post-closing services as well. He recommends comparing when and how you’ll be able to access funds, whether there are mobile management options and whether there are prepayment penalties for your loan or line of credit. Factoring in servicing features along with rates and protections will give you a full picture of what you can expect from working with a lender.
How home equity loans work
When you take out a home equity loan, you receive all of the funds in a lump-sum payment. You’ll make fixed-rate, regular monthly payments for a set time period, usually between five and 15 years.
There are no prepayment penalties or annual fees, and you can pay extra every month to reduce the balance faster if you have some extra cash. Home equity loan rates are typically much lower than those for credit cards or personal loans, making these loans more attractive than other financial products when you need a large amount of cash upfront.
Home equity closing costs
Closing costs for home equity loans range from 2% to 5% of your loan amount. Lenders may offer you a number of different closing cost options like discounts on fees, while others may offer a slightly higher rate for lower-cost options. The table below shows the most common home equity loan closing costs.
|TYPE OF FEE||AMOUNT||WHY IT’S CHARGED|
|Loan application fee||Varies||To set up your loan paperwork|
|Credit report fee||$17 to $75||To check your credit history and FICO Scores|
|Processing and underwriting||$200 to $500||To cover the lender’s costs for processing and approving your loan|
|Appraisal fee||$300 to $400||To pay for an inspection and report that analyzes your home’s value|
|Tax monitoring and service fee||$85 to $100||To verify that your property taxes are paid on time|
|Flood certification fee||$10 to $20||To confirm whether or not the property is in a flood zone|
|Title search and lender’s title insurance||$1,000 to $1,500||To protect the lender against financial loss if there are title claims on your home|
|Settlement fee||$150 to $750||To pay the escrow officer or attorney for preparing and supervising the loan closing|
|Recording fee||$150 to $300||To pay for recording the new lien on your home|
Alternatives to home equity loans
What to do if you don’t qualify for home equity products
From a lender’s perspective, issuing a home equity loan or line of credit is riskier than giving someone a mortgage. Kapfidze explains that the mortgage lender has the first lien, meaning that they’ll be repaid first if you default on your loans. Because the home equity lender has the second lien and therefore carries more risk, their approval thresholds are likely higher. This means that your chances of qualifying for a home equity product may be lower.
However, if you still need access to a large sum of money, you may qualify for a cash-out refinance. In this case, you would refinance your current mortgage for a higher dollar amount that includes the remaining balance on the loan plus additional funds you can use for renovations and other needs. The difference between the two is what’s available for spending. Kapfidze notes that consumers can see higher interest rates on their refinanced mortgages than on their existing mortgages, so it’s important to be aware of the additional costs you’ll incur before pursuing this option.
If you’re not sure whether a home equity loan is best for your situation, you have a number of different ways to tap your home’s equity. Here are three of them:
HOME EQUITY LINE OF CREDIT (HELOC)
A HELOC works similar to a credit card with a revolving line of credit that you can draw on when needed. Because your home is used as collateral to secure the loan, you could lose it if you fail to repay the HELOC.
Typical features include:
- A “draw” period (typically 10 years) when the balance can be charged and paid off as needed.
- Payments based only on how much you draw.
- Interest-only payment options.
- May come with annual fees, prepayment penalties and other maintenance fees.
- Installment payments for the balance due once the draw period ends.
If current rates are low, it may be worth replacing your existing mortgage with a larger loan amount and pocket the difference in cash with a cash-out refinance. As with home equity loans and HELOCs, your home is used to secure a cash-out refi, so you can lose it if you default on the loan.
Typical features include:
- Lower interest rates than other types of equity loans.
Higher closing costs, because the loan balance is higher than a home equity loan.
- Ability to borrow up to 80% of your home’s value with a conventional or Federal Housing Administration (FHA) cash-out refinance.
- Ability to tap up to 90% of your home’s value with a cash-out refinance loan backed by the U.S. Department of Veterans Affairs (VA) if you’re an active-duty military service member, veteran or eligible spouse.
Homeowners who are 62 years or older may be eligible for a reverse mortgage, which allows them to convert a portion of their home equity into a lump sum of cash, a line of credit, monthly income or a combination of all of the above.
Advantages Of Home Equity Loans
The benefits of home equity loans and lines of credit
Both HELs and HELOCs provide access to funds and offer a means to cover important expenses.
Kapfidze says that because home equity products are backed by your house as collateral, you’ll often secure better interest rates than you would through a personal loan or credit card. That’s why some consumers will use home equity to purchase cars or pay off student loans, because they’re able to secure better interest rates that way.
Whether you choose a home equity loan or line of credit depends on your particular circumstances.
Depending on how you use your loan, you may qualify for a tax deduction. You may choose to limit your home equity spending based on new tax limitations as well. The Tax Cuts and Jobs Act stipulates that you can only deduct interest paid on a home equity loan or line of credit if you use the funds to renovate, build or purchase the house that secures the loan, according to the IRS.
Who home equity loans are best for: Kockos says that home equity loans make sense for consumers who know they need a set amount of cash right away. If you’re facing a major expense with a set dollar amount — a medical procedure or a roof replacement, for instance — you may want to take out a loan for the exact amount you want to borrow. You can then lock it in at a fixed interest rate and you’ll know what your monthly payments will be for the duration of the loan.
Who HELOCs are best for: A home equity line of credit may make more sense if you want access to a certain amount of money but don’t necessarily want to use it all immediately. Unlike with an HEL, you’ll only pay on what you’ve already drawn from a HELOC. Kockos offers the example of using a HELOC to cover home remodeling expenses. You might be approved for $100,000 but you may not pay all of your contractors at once. Instead, you might pay $25,000 to one vendor this month and $10,000 to another next month. If that’s the case, you’d use your credit line as each expense comes up, and you only pay interest on the funds you’ve already drawn.
David Gorman, a division executive at Bank of America, says a home equity line of credit has become increasingly popular among both lenders and borrowers. “You very rarely see home equity loans anymore,” he said.
He attributes this shift to the flexibility of HELOCs. Even consumers who want to lock in a fixed rate can do so on their lines of credit, he explains. If you spend $30,000 of an $80,000 line of credit on roof repairs, you can lock in that $30,000 at a fixed rate to avoid significant interest increases during repayment. This provides some of the security of a home equity loan without sacrificing the benefits of the HELOC.
“It acts almost the same, and they don’t have to take it all out upfront,” Gorman said. “It provides you significant flexibility.”
Home Equity Loan Risks
The number one risk you must be aware of when you apply for a home equity product is that you’re borrowing against your home, and your lender can foreclose on it if you don’t make your payments.
“You’re risking your house, whereas with other types of loans, you may pay a higher interest rate but you’re not putting your house ‘on the line,’” Kapfidze said. Consumers should be well aware of that risk when applying for a home equity product, he added, but if they go into it with a full understanding of the terms, they’ll find that they are likely to get the best rates through these options.
Knowing that your house is at stake makes it vitally important to think carefully about how you spend your home equity funds. You can use the money however you choose, whether that’s to repair your basement after a flood or take a second honeymoon. However, paying for nonessential renovations or family vacations leaves you with less money to cover emergencies, not to mention with potentially significant debt that could become difficult to repay. Gorman says that Bank of America doesn’t advise borrowers on how to spend their money, but he says that misuse of funds is one of the biggest pitfalls that ensnare consumers.
“Should they actually need the equity in their house for other things down the road, they may no longer have it,” he said.
Home equity loan FAQS
WHAT IS HOME EQUITY?
Home equity is the difference between your home’s market value and what you currently owe. As you pay your mortgage balance down and home values increase over time, home equity usually grows, too.
HOW IS HOME EQUITY CALCULATED?
To calculate how much home equity you have, subtract the outstanding loan balance from the value of your home. For example, if your home is worth $200,000 and your mortgage balance is $150,000, you have $50,000 of equity.
HOW MUCH CAN I BORROW FOR A HOME EQUITY LOAN?
Most home equity lenders let you tap up to 85% of your home’s equity. Some lenders may allow you to borrow more.
WHAT IS THE AVERAGE INTEREST RATE ON A HOME EQUITY LOAN?
Home equity loan interest rates change with the financial markets, but are typically lower than other forms of borrowing, such as personal loans or credit cards.
HOW LONG DOES IT USUALLY TAKE TO GET APPROVED FOR A HOME EQUITY LOAN?
It may take two to four weeks to close on a home equity loan. You may receive the funds at closing or a few weeks later, depending on the lender.
DOES A HOME EQUITY LOAN IMPACT YOUR CREDIT?
Making late payments on a home equity loan could damage your credit score. If you default on a home equity loan, you could lose your home because your home is the collateral that secures the loan.
CAN YOU GET A HOME EQUITY LOAN WITH BAD CREDIT?
Yes, but interest rates will be higher and there will be more LTV restrictions.
IS A HOME EQUITY LOAN TAX DEDUCTIBLE?
If home equity loan funds are used for home improvement, the loan interest can be deducted on your annual tax bill.
I am David, economist, originally from Britain, and studied in Germany and Canada. I am now living in the United States. I have a house in Ontario, but I actually never go. I wrote some books about sovereign debt, and mortgage loans. I am currently retired and dedicate most of my time to fishing. There were many topics in personal finances that have currently changed and other that I have never published before. So now in Business Finance, I found the opportunity to do so. Please let me know in the comments section which are your thoughts. Thank you and have a happy reading.