If you own a home and you need to borrow money, a home equity loan may be an option worth considering. A home equity loan can help you get cash for home improvements, debt consolidation or other major expenses using the value you’ve built up in your home as a financial resource.
But getting a home equity loan is an extensive process — and there are still some risks. It’s important to make an informed decision that’s based on your unique situation and needs.
In this article, we’ll explain how a home equity loan works and how to apply for one. We’ll also go over some questions to consider to help you choose the best loan option for your situation.
Understanding Home Equity Loans
A home equity loan allows you to borrow money against the equity you currently have in your home.
Equity is the amount that your property is worth minus what you owe on your mortgage. If you have a home that’s worth $350,000 and you still owe $175,000 on your mortgage, you have equity of $175,000 — or 50%. Lenders generally allow you to borrow a certain percentage of your equity, so the more equity you have in your home, the more you’ll be able to borrow.
When you take out a home equity loan, you generally borrow money as a lump sum then pay it back at a fixed interest rate over a period between five and 20 years. There are also typically upfront costs and fees usually paid as part of your closing costs. Your home is used as collateral, so home equity loans are also often referred to as a second mortgage.
Home equity loans are different from home equity lines of credit (or HELOCs), which are another way to borrow from your home equity. With a HELOC, you’re given a revolving line of credit that works much like a credit card. You can continually borrow and repay money from your credit line during a period of time known as a draw period, a fixed term that can last for up to 10 years. After the draw period ends, you enter the repayment period where you must make regular payments (covering both the principal balance and interest) over a fixed term.
Determining If a Home Equity Loan Is Right for You
A home equity loan is not always the best option for everyone, but it can be useful in certain situations.
Home equity loans are often used for significant expenses, such as home renovations, educational expenses or paying off high interest credit card debt. That’s because these loans can be a convenient way to borrow a large sum of money at a relatively favorable interest rate.
But home equity loans can also be riskier than other options. If you fail to repay the loan, your lender could seize your home through foreclosure — so it’s important to make sure you only borrow what you can afford to repay on time.
Home equity loans also come with closing costs and other fees that should be factored into your decision. And not everyone will be able to qualify for a home equity loan, either.
Each lender has its own loan requirements, but you generally need to have a good credit score, a debt-to-income (DTI) ratio below 43% and enough equity in your home.
About Your Debt-To-Income Ratio
Your debt-to-income (DTI) ratio represents all your monthly debt payments divided by your gross income, and it’s a key metric lenders use to determine whether you can afford to take on any additional debt. Someone with a high DTI ratio due to possessing other forms of debt can have a harder time qualifying for a home equity loan.
For example, say you earn a salary of $6,000 per month and have a mortgage payment of $1,500 per month, a car payment of $300 monthly and a student loan payment of $150 a month. Your debt-to-income ratio would be about 33% ($1,950 divided by $6,000).
About Your Equity
Home equity lenders will also consider your loan-to-value (LTV) ratio, which compares the remaining amount of your mortgage to your home’s appraised value. The more equity you have in your home, the lower your LTV ratio is, and this will increase your chances of getting approved for a home equity loan.
Many lenders will allow your loan-to-value ratio to be no more than 80% after taking out a home equity loan. In the example above, if you have a home worth $350,000 and a mortgage balance of $175,000, you may be limited to borrowing $105,000 as a home equity loan. That’s because adding the $105,000 home equity loan to your mortgage balance equals $280,000 — or 80% of your home’s value.
Questions To Consider When Deciding on a Home Equity Loan
With all that in mind, here are some questions to ask yourself to assess your financial situation before applying for a home equity loan:
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Do I have a stable income and a good credit score?
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Do I have other debts to pay off right now, and can I also handle an additional loan payment?
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Are interest rates relatively low right now compared to other loan options?
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Can I afford additional costs like closing costs and other loan fees right now?
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Can I still manage this debt if I experience an unexpected financial setback, such as losing my job?
Pros of Home Equity Loans
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One fixed monthly payment: Home equity loans typically have a fixed rate, which allows you to have predictable payments over your loan repayment term.
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Lower interest rate: Since home equity loans are secured debt, you may have a lower interest rate compared to other types of loans, especially if your credit score is good.
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Interest may be tax-deductible: If you use your home equity loan funds to buy, build or make substantial improvements to your qualified home, you may be able to deduct the interest you paid on your annual taxes.
Cons of Home Equity Loans
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Risk of losing your home: Since your home is required as collateral, you risk losing it to foreclosure if you fail to make your payments on a home equity loan.
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High equity and credit score requirements: If you don’t have at least 20% equity in your home or a good credit score, you may not qualify.
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Fees and closing costs: Closing costs for home equity loans can range from 2% to 6% of the loan amount, which can make this loan option costly.
Alternatives to Home Equity Loans
If you feel that a home equity loan is not the best option for you right now, there are still other alternatives.
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Personal loans: Personal loans are typically unsecured, meaning they don’t require collateral and are usually paid back at a fixed rate. The interest rate for personal loans may be higher than a home equity loan, and your repayment term may also be shorter — often ranging from a maximum of five to seven years.
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HELOC: A home equity line of credit can be helpful if you need to borrow money on an ongoing basis rather than receiving a lump sum. HELOCs still require you to have equity in your home, and they usually have a variable interest rate so your payments could change over time.
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Cash-out refinancing: A cash-out refinance loan allows you to refinance your mortgage by replacing your current loan with a loan for a higher amount. When you close on the new loan, you can receive the difference as a lump sum of cash and start repaying the new loan. Cash-out refinancing is ideal when refinance rates are lower, but the main drawback is having to take out a larger mortgage amount — which will also likely increase your monthly house payment.
How To Apply for a Home Equity Loan
Before applying for a home equity loan, you’ll want to check your credit to make sure it’s in good standing and that your debt-to-income ratio doesn’t seem too high.
If you think you qualify for a home equity loan, the next step is typically to contact a few different banks or lenders to see if you can get preapproved. This will allow you to compare offers from a few different sources, helping you get the best deal.
Once you decide on the best home equity loan lender for your particular situation, you’ll proceed to a full loan application. You can start gathering documents like proof of address, your most recent check stubs, your current mortgage information and bank statements, which will help your lender verify your income. In most cases, your lender will also order a home appraisal to verify your equity.
From start to finish, the process of getting a home equity loan can generally take four to six weeks depending on the lender. Loan funds are usually dispersed as a lump sum as a check or deposit into your bank account.
Tips for Getting the Best Home Equity Loan
To get the best home equity loan, it’s best to compare different lenders — focusing especially on their rates and loan terms. In many cases, you can get a sense of what you qualify for by prequalifying with a few different lenders. This typically does not result in a hard inquiry on your credit report until you decide to move forward and apply.
Be sure to ask lots of questions early on and whether any terms are negotiable. It doesn’t hurt to ask lenders if they could lower certain fees or possibly even give you a slightly lower interest rate if you set up automatic monthly payments. Also, let lenders know you’re shopping around, and they may even cancel prepayment penalty fees (if they exist) or provide discounts on the cost of the appraisal or other closing costs.
It can also help to maintain a good credit score and also pay down outstanding debt to get a lower debt-to-income ratio. People with the highest credit scores generally qualify for the lowest interest rates, making it easier to pay back a loan. If you don’t currently qualify for attractive loan terms, you may choose to focus on improving your credit score and credit profile before applying for a home equity loan.
The Bottom Line
A home equity loan can be a helpful financial tool, but only if it makes sense for your budget and personal situation.
If you decide to move forward with a home equity loan, evaluate your finances and make sure you meet the minimum requirements. It may also help to set aside some funds as a financial cushion in the event of a financial hardship since this is such a high-risk loan. Then, shop around to compare lenders and loan rates to help ensure you’re getting the best deal.
Source: Marketwatch