Home equity loans are a type of second mortgage which let you borrow money against the current value of your home.
If you’ve built up enough equity, then you can take out a home equity loan against your home’s value. Home equity is the difference between your home’s current value and the outstanding balance on your original mortgage.
Home equity loans are commonly used when people need to pay for a large expense, including debt consolidation, home improvement projects, business funding, and more.
How Home Equity Loans Work
To see how home equity loans work, let’s take a look at a quick example.
Say you originally borrowed $200,000 to purchase your home. Now, after making payments for a while, your mortgage balance has dropped to $100,000. Also in the time since you bought your home, its value has increased to $250,000.
In this case, you would be able to borrow up to $150,000 against your home’s equity, as that’s the difference between your mortgage balance and your home’s value.
If approved, you would be able to borrow this amount in cash to be repaid over time.
Keep in mind that home equity loans use your home as collateral. This makes these loans easier to qualify for, but also makes them riskier for borrowers.
Home Equity Loans vs. Home Equity Lines of Credit
When looking for home equity loans, you might also see mention of home equity lines of credit (HELOCs). Both can be great options, but it’s important to understand the differences.
As mentioned above, home equity loans allow you to borrow a lump sum of money to be repaid over a predetermined amount of time with a set interest rate — just like any other loan.
Alternatively, a HELOC is more like using a credit card. You’ll be given a line of credit (the limit of which is, at most, the total equity), and you can borrow as much as you need up to that amount. This option is generally more flexible as you only have to pay interest on the money that you actually use.
HELOCs generally have variable interest rates, whereas home equity loans often have fixed interest rates.
Should You Get a Home Equity Loan?
Home equity loans often make sense for people who need a lump sum of money for large purchases.
However, as with anything else, home equity loans have their pros and cons.
Home equity loans have a number of great advantages, including:
Low Interest Rates: Home equity loans are secured by your property, so they typically have lower interest rates than unsecured debts.
Tax Deductions: You might be able to deduct the amount you pay in interest if the loan is used for home improvement purposes.
Fixed Payments: Home equity loans generally have a fixed payment schedule.
Loan Amount: A home equity loan can be very large as long as you have enough equity to cover it.
Overall, home equity loans are often a much better option than personal loans when you need a large sum of money.
While these loans can be a great option, they are not without their disadvantages. Some of these cons include:
Risk: If you fail to make payments you may lose your home to foreclosure.
Closing Costs: Unlike personal loans, you’ll have to pay closing costs. These can be quite expensive.
Selling Your Home: Since home equity loans are secured by your home, you’ll be required to immediately pay off your loan in its entirety if you sell your home. Meaning you’ll have to pay off your first and second mortgage all at once.
Despite these risks, the right home equity loan can be a great way to get access to a large sum of money with great repayment terms.
How to Get a Home Equity Loan
Getting a home equity loan doesn’t need to be a difficult process. There are just a few steps you should take before applying for a loan.
Calculate Your Equity
First and foremost, you need to calculate your home equity. If you don’t have any equity, or you only have a little bit, a home equity loan may not be an option.
Home equity is simply the value of your home minus what you owe on your mortgage. The amount that you can borrow is based on your loan-to-value ratio.
If you need help calculating your equity, you can use a home equity calculator.
Know Your Credit Score
Like with any other loan, your credit score is an incredibly important factor.
Your credit score will determine how much you can borrow, your interest rates, and your loan term.
For home equity loans, you’ll often be required to have a credit score of at least 620.
Find a Lender
Finding the right lender for you is the most important part of this process.
The most crucial aspect of shopping for lenders is to compare offers from as many lenders as possible. This will help ensure that you find the best rates and terms available for your loan.
Be sure to explore all of your options, including private lenders and credit unions. Banks are the most common choice, but don’t necessarily offer the best terms.
If you’re not sure where to start looking, you can check out Bankrate’s list of best home equity loan rates.
Apply for Your Loan
After you find the right lender for you, all you need to do is fill out and submit your application. The application will typically consist of basic financial information, such as:
If your application is approved, you’ll be given an offer which dictates your interest rate and loan term.
If you are happy with these terms, all you have to do is close the deal to receive your money.
Frequently Asked Questions
Are there any alternatives to home equity loans?
HELOCs are one of the primary alternatives to home equity loans. Instead of receiving a lump sum of money, you can borrow as little or as much as you need, up to the limit of your line of credit.
Alternatively, you can consider cash-out refinancing. This involves replacing your current mortgage with a new mortgage based on your home’s increased value.
Home much equity do I need?
Every lender will have its own requirements, so be sure to ask your lender how much equity is required in order to be approved.
Generally, you should aim for at least 15% to 20%.
What if I have bad credit?
Fortunately, home equity loans are still obtainable if you have bad credit.
Since home equity loans are secured by your property, they are much easier to be approved for, even if your credit isn’t the best.