When you’re first getting a mortgage, you might not think ahead to getting a home equity loan, though some homebuyer’s guides may cover them.
However, as your life evolves, you may find you need to borrow from the equity you have in your home. Your home can offer more than just a place to live or an investment opportunity.
What is a home equity loan?
Let’s go over the details of a home equity loan, how you can access the equity in your home and the pros and cons of taking out this type of loan.
What is a Home Equity Loan?
A home equity loan is a second mortgage that allows you to tap into your home’s equity by borrowing from it. Your equity refers to the amount you’ve paid on your first mortgage. A home equity loan doesn’t replace your first mortgage. Instead, you get a second mortgage with a higher interest rate.
The interest rate is higher because the second mortgage ranks lower on the payment priority list. In other words, if you can only make payments on one mortgage, your first mortgage takes priority. This makes the second mortgage riskier for your lender, hence the higher interest rate.
Generally, you can borrow up to 85% of your home’s value, minus your outstanding mortgage balance.
Home Equity Loan vs. Home Equity Line of Credit (HELOC)
Home equity loans almost always have fixed interest rates instead of variable interest rates. They also have fixed monthly payments. You typically repay the loan up to 30 years.
You may have also heard of home equity lines of credit (HELOCs). A HELOC gives you a revolving line of credit, similar to a credit card. You borrow as much or as little as you need throughout your draw period and up to your credit limit.
You begin repaying as soon as your draw period ends. The draw period usually lasts up to 10 years and your repayment period usually lasts 20, though it depends on what you arrange with your lender.
You put up your home as collateral for both a home equity loan and a HELOC, which means that if you fail to make payments on either, you could lose your home through foreclosure.
How Does a Home Equity Loan Work?
A home equity loan gives you a lump-sum payment after your loan closes. You pay the loan back in fixed installments over a predetermined period. Your interest rate remains the same throughout the term of the loan.
After you receive your loan amount, your monthly payments will include both principal and interest. A shorter loan term, such as a 10-year term, will require you to make higher monthly payments than a longer loan term, like a 30-year term.
When Should You Consider a Home Equity Loan?
You might want to consider a home equity loan if you have:
- At least 15% equity built up in your home: Lenders typically only approve a home equity loan with an LTV of up to 85%. Your lender may also accept a combined loan-to-value ratio (CLTV) of 85%, which means that adding up your mortgage and your desired loan amount can make up no more than 85% of your home’s value.
- Good credit: Your credit score, a three-digit number, shows how well you pay back debt. To get the best interest rates for a home equity loan, you should have a high credit score, which depends on your lender’s requirements.
- A good debt-to-income ratio: You’ll also have to share your debt-to-income (DTI) ratio. DTI compares your monthly debt payments to your monthly income. You can calculate your DTI by adding up your monthly bills and dividing that figure by your gross monthly income. You can then multiply that calculation by 100 to get a percentage. Lenders generally want to see a DTI of less than 43%.
- Proof of income: Your lender will need to know how much you earn and will want to see current pay stubs, W2 forms or tax records. You can offer proof of other assets, such as rental properties and even proof of alimony or child support if you can count it as an income source.
How Do You Apply for a Home Equity Loan?
Let’s look at the following steps to get a home equity loan.
- Evaluate your finances. You can check your credit report errors, calculate your home equity and calculate how much debt you already have. Many lenders let you start the application process online by entering your personal and financial information.
- Gather your documents. You may need to obtain a few documents for your lender, including your Social Security card, W-2 statements, pay stubs, current mortgage statement and more. Your lender will walk you through the items you need to provide.
- Apply online. Once you gather your items, you can apply for a home equity loan online.
- Your lender will have your home appraised. A home appraisal tells lenders how much your home is worth. You may have to pay a fee to get an appraisal.
How Much Can You Borrow Against Your Mortgage?
Your loan-to-value ratio (LTV) refers to the difference between the appraised value of your home and your current mortgage balance. It also tells you how much you can borrow against your mortgage.
Let’s look at an example of how you can calculate this on your own based on 85% of your home value.
Value of Your Home x 0.85 = X
X – Remaining Balance of Your Mortgage = Amount You Could Secure from a Home Equity Loan
Let’s use some real numbers. We’ll say that the value of your home is $200,000. You have a $100,000 remaining balance on your home loan. Here’s how you use that same calculation:
$200,000 x 0.85 = $170,000
$170,000 – $100,000 = $70,000
In this particular example, you could receive $70,000 from a home equity loan.
The Benefits of Taking Out a Home Equity Loan
Why take out a home equity loan? You may choose to get a home equity loan instead of other types of loans for the following reasons:
- You can use the money for anything you want.
- You can access the funds immediately because your lender will give you a lump sum.
- You’ll know exactly what to expect to repay because payments are fixed.
- If you use the loan for home improvements or renovation, the interest may be tax-deductible.
The Drawbacks of Taking Out a Home Equity Loan
On the other hand, home equity loans come with the following downsides:
- You’ll have two mortgages. A home equity loan functions as a second mortgage in addition to your primary mortgage.
- You put your home up as collateral for the home equity loan, which means that if you default on your loan, you could lose your home.
- You’ll have to pay off your home equity loan and your primary loan if you happen to sell your home.
- You’ll have to pay closing costs, unlike with some other consumer loans.
- They offer less flexibility than a home equity line of credit (HELOC). You can’t withdraw money from a home equity loan like you can with a HELOC. A HELOC allows you to receive replenished funds as you pay your outstanding balance.
Examples of How You Can Use Your Home Equity Loan
You can use a home equity loan for many different reasons, including (but not limited to) the following:
- Renovations: You may want to make renovations to your home, such as finishing an unfinished basement or expanding the size of your master bedroom.
- Debt consolidation: If you have other types of debt with a higher interest rate, such as credit card debt, you can use a home equity loan to pay off the debt.
- College: If you can only find high-interest student loans, you can even consider using a home equity loan to pay for college.
You can tap into endless possibilities for using your home equity loan.