How does a home equity loan work?
As you pay down your mortgage — or your home increases in value from what you originally paid for it — your home equity increases.
For example, if your home is currently worth $250,000 and you have a mortgage balance of $175,000 remaining, you have $75,000 of equity. It’s how much money you’d be left with if you sold the property.
Using that equity as collateral, you can ask a lender to let you borrow a large sum of money, which you can use for things like major home improvement projects.
You’ll get one lump sum payment, which you’ll be expected to pay back over time at a fixed interest rate. It’s structured as an amortizing loan, which means you make equal payments over a set period of time. At the beginning, much of that payment goes to interest, but over time more will go toward the principal and reduce what you owe.
How much can you borrow?
Typically, lenders will allow you to borrow up to 80% of your equity. If we refer back to the example of your $75,000 of equity in your $250,000 home, you could take out up to $60,000 in a loan.
Some lenders will offer you access to more than 80%, but they’ll charge you a higher interest rate for it.
The minimum you can take out for a home equity loan ranges from $10,000 to $25,000.
Home equity loans became very popular following the passage of a tax law in 1986. The law axed the deduction for interest paid on credit cards, car loans and other consumer borrowing, but it allowed Americans to keep deducting the interest on home loans.
That led homeowners to rely on home equity loans whenever they needed a big chunk of cash, because they could write off the interest.
Today, home equity loans are less of a free-for-all for taxpayers. A 2017 tax law suspended deductions for interest paid on home equity loans and lines of credit, unless they are being used to buy, build or substantially improve a home. This new policy came into effect in 2018 and remains in force until 2026.
Benefits of a home equity loan
There are some solid benefits to going with a home equity loan. Here’s a few:
- It gives you access to a large sum of money when you need it.
- The process of getting one is much easier than finding an unsecured loan (a loan where you don’t have to put up any of your assets as collateral).
- You’ll be offered steadier and more attractive interest rates with a home equity loan compared to the rates you’d face with a credit card or personal loan.
- Compared to a home equity line of credit (HELOC) or credit card payments, you’ll have more predictable, fixed payments.
Drawbacks of a home equity loan
But we did say it was a bit risky. Here’s how:
- The loan is secured by your house, so you could wind up losing your home to foreclosure if you don’t pay it back.
- If you decide to sell your house and move before you’ve finished repaying your loan, your lender will expect you to pay it back immediately in full.
- Like when you took out your first mortgage, there will be closing costs associated with your home equity loan. It will cost you to take this money out, usually 2% to 5% of the total loan amount, according to LendingTree.
- You don’t get the same kind of flexibility as you would with a HELOC. A loan gives you a lump sum of money at once, but a line of credit offers you the option to take out just what you need on demand. But we’ll get into HELOCs more later.
- And if you only plan to use the loan gradually, you’ll still have to start repaying the entire sum right away.
How to get a home equity loan
The first thing you’ll want to do here is a little research. Shop around and check out a few different lenders and review their offerings. You’ll want to look for the lowest interest rate, as few fees as possible and a good repayment plan that works for your budget.
How to qualify
To qualify, you’ll have to have already accrued a good amount of equity in your home. You’ll also need to show you have money coming in through secure employment.
Next is your debt-to-income ratio. It may sound like a complicated concept, but basically, this is a formula that shows lenders your ability to manage your debt repayment. To calculate your ratio, you add up all of your monthly debt payments and then divide that number by your gross monthly income.
So let’s say you pay $1,650 on your mortgage every month, $250 for your auto loan and $600 on various other debts. That totals $2,500 in monthly debt payments. If your gross monthly income is $5,000, then your debt-to-income ratio is 50%.
To qualify for a home equity loan, your lender will want your ratio to be less than 43%. If your ratio is any higher than that, you’re seen as more likely to have issues paying off your debts.
Some lenders may consider you for a loan if your ratio is up to 50%, but they’re going to ask to see some evidence that you’ll be able to keep up with your payments.
Your credit score will also come into play here. You’ll want to have at least a 620 rating. If your score is not quite up to snuff, you might want to look into a credit monitoring service like Credit Sesame — or, if you have a long way to go, a credit repair company like Self.
Overall, before you apply, you’ll want to be sure you have enough equity, your debt-to-income ratio falls under 43% and your credit score is high. Otherwise, you aren’t likely to qualify for the best rates.
Pitfalls to avoid
Some lenders will charge you interest on the day you sign your loan, which could be an unpleasant surprise.
There’s also the possibility that they will try to fold an insurance package into your payment plan. You’ll want to seek out your own insurance here to ensure it meets your needs, not just the lender’s.
But your biggest risk is that your lender sets your payments at a rate you can’t keep up with. Remember, you’ve offered your house as a collateral in this loan. If you default on your payments, you’re at serious risk of losing your home.
Alternatives to home equity loans
If you’re in need of a cash infusion, a home equity loan isn’t your only option. There are some solid alternatives you can explore.
A home equity line of credit (HELOC) is a different kind of loan that still borrows against your home equity.
A HELOC is a revolving loan, similar to a credit card. You’re given a “draw period,” where you can withdraw any amount within your limit at any time. And you’re only required to pay the interest for what you withdraw during the draw period.
During that time, you can draw and repay and draw again as you please. But once the period has ended, you won’t be allowed to take out more money. And in contrast to home equity loans, a HELOC is usually offered with a variable interest rate.
Read more on the differences between HELOCs and home equity loans.
A cash-out refinance is a way to refinance your mortgage and get a little money back at the same time. It’s the same concept as when you get “cash back” at a grocery store — you pay for your groceries and tack on a little extra to your bill so the cashier can give you that extra amount back in cash.
Because this is refinancing, your interest rate will change. This is an option that makes sense if the interest rate on offer is lower than the rate you have on your existing mortgage, but not so much if you’re happy with the rate you’re currently paying.
Maybe after a second look at your upcoming expenses, you’ve decided you don’t actually need all that much money. If that’s the case, you should consider an unsecured personal loan instead.
With a personal loan, you’ll face higher interest rates and tougher requirements, but you’re also not putting up your home as collateral.
It can be overwhelming to sort between all the different options out there, especially when you have a big project, purchase or financial obligation on the horizon.
Home equity loans are a great option to get a hefty sum in your hands at a low interest rate. But before you take on a second mortgage, make sure you give your decision as much time as you did your first.
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