What is a Home Equity Loan?
It’s an excellent way to capitalize on your home’s value. It’s a way to use your property to achieve your financial goals. Let’s look at how Home Equity Loans work, and how one could work for you.
The Basics of Home Equity Loans
- With a Home Equity Loan, also known as a second mortgage, you borrow against accumulated home equity. You get a lump sum in cash and repay that amount in monthly installments over a set term, just like a primary mortgage.
- How much can you borrow? You may be able to borrow up to 97% of the Combined Loan-to-Value (CLTV) ratio. You determine CLTV by dividing a property’s appraised value by the balance of loans secured against that property.
- Take, for example, a home appraised at one million dollars with $500,000 owed on one mortgage. That’s 50% CLTV. Therefore, you could probably take out a Home Equity Loan of up to $470,000. Home Equity Loans typically start at around $100,000 and go up to about $500,000.
Home Equity Loans usually have fixed interest rates.
Similar to primary mortgages, Home Equity Loans have closing costs. These are often between 2% and 5% of the loan amount.
Who can benefit from a Home Equity Loan?
Most homeowners with sound financial plans can benefit from a Home Equity Loan. Some of the most popular uses are:
- Home renovations. Kitchen and bathroom remodels. Decks and pools. Energy-efficient upgrades and more. People often use their home’s equity to improve their home and increase its value.
- Debt consolidation. Credit cards and personal loans are often high-interest debts. You could pay them off with a lower interest Home Equity Loan.
- Large one-time expenses. Most families face them. From college tuition and weddings to medical bills and more, your home could help cover the biggest expenses in your life.
- Investments. Real estate investors often leverage one property’s equity to buy another that generates income. Home Equity Loans are also popular for starting small businesses.
- Emergency funds. A financial safety net provides peace of mind. You can use a Home Equity Loan to set up readily available funds in cash or cash equivalents, such as Treasury bills and money market funds.
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Home Equity Loan vs. HELOC: What’s the Difference?
Home Equity Loans and HELOCs (Home Equity Lines of Credit) each let you borrow against your home’s equity. Each is considered a second mortgage. Home Equity Loans and HELOCs, however, work differently
HELOCs are like credit cards: you can borrow money as needed. Here, a mortgage professional approves a credit limit. You can then withdraw cash up to that limit during the “draw period,” typically five to ten years.
Like a credit card, you repay what you borrow in monthly installments, paying interest on the amount drawn. HELOC repayment periods are typically between ten and 20 years. So, for example, after credit approval, you may have available funds for five years and five additional years to pay the money back.
HELOCs typically have variable interest rates that are usually comparable to rates for conventional mortgages. With Home Equity Loans and HELOCs, interest can be tax deductible if you use the money to buy, build, or improve properties.
The Pros and Cons of Home Equity Loans
Pros include:
- Attractive interest rates. What’s the average interest rate on a credit card? Around 20%. Personal loans? They average about 12%. Home Equity Loans, however, generally have significantly lower interest rates than these.
- Predictability. Home Equity Loans usually have fixed interest rates; you’ll know the exact amount you’ll pay each month. This helps with stable, predictable budgeting.
- Tax benefits. If you use the money to buy or improve a property, the IRS lets you deduct interest paid on up to $750,000 of a Home Equity Loan.
- Easier approval>. Home Equity Loans are secured loans; they are backed by a home’s equity. Mortgage professionals tend to favor secured loans and approve them faster than unsecured loans backed only by creditworthiness.
- Longer repayment terms. While most Home Equity Loan repayment terms are between ten and 15 years, they can be as long as 30 years. Spreading the repayment over decades keeps the monthly cost lower.
Cons include:
- Risk. You take on the same risk as your primary mortgage; the inability to make loan payments could put your house in jeopardy.
- Interest considerations. Even if you use the money incrementally, you pay interest on the entire amount (unlike a pay-as-you-draw HELOC). If you spread out the term of a Home Equity Loan, you could pay more overall interest.
- Reduced home equity. Borrowing against home equity means you own less of your home. Should you sell the house before the Home Equity Loan is repaid, a portion of the proceeds will go toward loan repayment.
- Upfront costs. These often include an appraisal fee, an origination fee, a title search fee, and others. Closing costs are similar to those of a primary mortgage.
Requirements for Home Equity Loans
While requirements vary, some common guidelines include:
- Credit score. For loan approval, you usually need 600 or higher. Borrowers with 740s and higher often get the most attractive terms.
- Home equity. Mortgage professionals typically require at least 15% or 20% home equity.
- Debt-to-income ratio. 43% or lower is generally preferred.
- An appraisal. A mortgage professional will usually order one to determine the home’s fair market value and thus the amount you’re eligible to borrow.
How to Apply for a Home Equity Loan
Your mortgage professional can guide you through the steps. To prepare, get your documentation in order. This can include proof of income (pay stubs, W-2s, tax returns), mortgage statements, homeowners’ insurance information, and tax assessments.
You might consider prequalification. Here, without doing a credit check, a mortgage professional can take your basic information and give you a general idea of how much you may be able to borrow.