What a home equity loan is and how you can make it work for you

  • By Deborah Kearns,
  • Bankrate.com
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Home equity loans are a type of second mortgage that let you use your home’s value as collateral to pull out cash. Home equity is the difference between how much a home is worth and any debts against it, such as a primary mortgage.

When you take out a home equity loan, there are two ways to receive the cash:

  1. Lump-sum payment. You take out a large amount of cash up front and repay the loan over time at a fixed interest rate. This option is ideal if you have a large, immediate expense. It also comes with the stability of predictable second-mortgage payments.
  2. Line of credit. Once you’re approved for a maximum loan amount, you can borrow as much as you need whenever you want, up to the credit limit. This option, known as a home equity line of credit, or HELOC, gives you flexibility to borrow money as you need it but typically come with variable interest rates. Your payments are lower initially then become fully amortizing later in the loan term.

Home equity loans can help you pay for big expenses like a home renovation, high-interest debt consolidation or college expenses. If you need a large amount of cash, you may want to consider borrowing some of the equity you have built up in your home. But you should do so with care.

How does a home equity loan work?

Once you get a home equity loan, your lender will pay out a single lump sum. You can use the money to finance home renovations, consolidate credit card debt or other expenses. Once you’ve received your loan, you start repaying it right away at a fixed interest rate. That means you’ll pay a set amount every month for the term of the loan, whether it’s five years or 15 years.

How to calculate your home’s equity

Home equity is the difference between your home’s current market value and your mortgage balance. Here’s how to calculate how much home equity you have.

  1. Get your home’s current market value. What you paid for your home a few years ago or even last year may not be its value today. Online real estate search portals can provide a rough idea of your home’s current value, but they aren’t always accurate. A local real estate agent can give a more precise professional opinion of your home’s value. A lender will order a professional property appraisal to determine your home’s market value.
  2. Subtract your mortgage balance. Once you know the market value of your home, subtract the amount you still owe on your mortgage and any other debts secured by your home. The result is your home equity.

Are you eligible for a home equity loan?

To qualify for a home equity loan, here are some minimum requirements:

  • Credit score of 620 or higher.
  • Maximum loan-to-value ratio, or LTV, of 80 percent, but some lend higher (or 20 percent equity in your home).
  • Documented ability to repay your loan.
  • An approximate figure for how much you want to borrow.

Lenders have varying borrowing standards and rates for home equity products, so you’ll want to shop around to ensure you’re getting the best deal.

First, check your credit score. If your credit score is lower than 620, it may be difficult to qualify for a home equity loan. The minimum credit score requirement for a HELOC is typically higher. 

Lenders generally require a maximum LTV of 80 percent, or 20 percent equity in your home. LTV ratios compare the total mortgage aqnd home equity loan amount with the value of the property, usually with a property appraisal. In other words, lenders want to see that you will still have at least 20 percent equity in your home.

Lenders will check your financial documentation, credit score, debt-to-income ratio, income and employment to ensure you can repay the loan or line of credit, so be prepared to submit this documentation.

Finally, know how much you want to borrow and what you’re using the money for. Home equity loans and HELOCs are long-term loans that take years to repay so don’t borrow more than you need – and avoid using them for frivolous splurges.

Benefits of a home equity loan

Home equity loans can be a useful tool when you need a large amount of cash upfront. Here are some benefits of home equity loans:

  • Lower interest rates: Home equity loans are secured by your home, so they have lower interest rates than other types of unsecured debt, such as credit cards or personal loans. This can help you save substantially on interest payments and improve monthly cash flow if you need to consolidate high-interest debt.
  • Stable monthly payments: With a fixed-rate home equity loan, you don’t have to worry about your payments fluctuating over time.
  • Tax benefits: The 2017 Tax Cuts and Jobs Act allows homeowners to deduct the mortgage interest on a home equity loan if the money is used “buy, build or substantially improve” the home that secures the loan.

Drawbacks of a home equity loan

  • Borrowing costs: Some lenders charge fees for a home equity loan. As you shop lenders, pay attention to the loan’s annual percentage rate (APR), which includes the interest rate and other loan fees. If you roll these fees into your loan, you’ll likely pay a higher interest rate.
  • Risk of losing your home: Home equity debt is secured by your home, so if you fail to make payments, your lender can foreclose on it. If housing values plummet, you could wind up underwater, meaning you owe more on your home than it’s worth. Your credit and finances could take a major hit, too.
  • Misusing the money: Your home isn’t an ATM, and experts recommend that you use a home equity loan for expenses that will pay you back, such as a home renovation that increases value, paying for college, starting a business or consolidating high-interest debt. Stick to needs versus wants; otherwise, you’re perpetuating a cycle of living beyond your means.

HELOCs: Another home equity lending option

A home equity loan isn’t the only type of loan that allows you to tap your home’s equity for cash. A HELOC offers another way to tap your home’s value.

A HELOC works more like a credit card that lets you withdraw on a line of credit up to a certain limit during an initial “draw” period. You’ll be able to pull money anytime you need it during this period, usually 10 years. As you pay down the HELOC principal, the credit revolves and you can use it again. This flexibility, while helpful, means you could pay significant interest charges if you take out a variable-rate HELOC and rates rise.

You can choose one of two loan options: interest-only payments, or a combination of interest and principal payments. The latter helps you pay off the loan more quickly. Most HELOCs come with variable rates, meaning your monthly payment can go up or down over the loan’s lifetime. Some lenders now offer fixed-rate HELOCs, but these tend to have higher initial interest rates.

After the draw period, you enter the repayment period in which any remaining interest and the principal balance are due and the interest rate becomes fixed. Repayment periods tend to be longer than draw periods — anywhere from 15 to 20 years. Using a HELOC for a substantial home improvement project may also be tax-deductible under the new tax law, too.

A home equity loan makes more sense for a large, upfront expense because it’s paid in a lump sum. If you have smaller expenses that will be spread out over several years, such as multiple home projects or college tuition payments, a HELOC may be better.

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