What is a home equity loan?
A home equity loan is a second mortgage. Just like a first mortgage, a home equity loan is a secured loan. If you don't pay your loan as promised, the lender can seize your home (collateral) and sell the property to recoup its losses.
One difference between home equity loans and other types of loans is that you may be able to deduct the interest if the funds are used to renovate or add on to your home.
Note: Before applying for a home equity loan, have a plan in place for what to do if you encounter a financial problem, such as an unexpected illness or job loss. Since your home is at risk, it pays to have an emergency fund that will ensure your payments are made no matter what happens.
How do home equity loans work?
When you take out a home equity loan, your funds are spread out in a lump sum and repaid in monthly installments. Home equity loans can be used for almost anything, including home maintenance and upgrades, travel, weddings, debt consolidation, and more. The interest rate and monthly repayment amount are fixed, so you can manage your finances with peace of mind. Home equity loans typically have lower annual interest rates than unsecured personal loans because your home secures the loan and reduces risk for the lender.
Most home equity loans have a loan term of 5 to 20 years, but can extend up to 30 years. Some mortgage lenders charge upfront fees and closing costs, while some lenders cover closing costs.
How much can I borrow?
The first requirement is that you have sufficient home equity to rent. Lenders typically require borrowers to have at least 20% of the home's value in equity. To find out how much equity you have available, your lender will request an appraisal of your home. The cost of the home appraisal will be added to the fee you pay at closing.
Let's say your home is valued at $350,000 and your mortgage balance is $200,000. That means you have $150,000 in capital. The next step is figuring out how much of that stock you're eligible to borrow. Lenders typically allow you to borrow up to about 85% of a home's current market value. This includes your first mortgage if you still have one. Each financial institution also has minimum and maximum loan amounts.
For example, if your home is worth $500,000 and you still owe a $150,000 mortgage, you may be able to borrow another $275,000 before your debt reaches 85% of the home's value.
85% of $500,000 is $425,000
A first mortgage of $150,000 and a home equity loan of $275,000 equals $425,000
However, if your lender has a home equity loan limit of $200,000, that's all you can borrow, even if you have more equity.
Home equity loan requirements
To qualify for a home equity loan, you will need to provide a series of documents to your lender, including:
W2 or 1099 income statements for the past two years Three months of bank statements Two years of federal tax returns Recent pay stubs Proof of other sources of income, such as Social Security or tips Proof of investment income
Lenders will also check:
Debt-to-income (DTI) ratio
To qualify, your DTI generally cannot exceed 43%. To calculate your DTI, add up your monthly payments (fixed expenses like your mortgage, car loan, child support payments, credit card payments, and other loan payments). Once you've calculated your total, divide that number by your gross monthly income (the amount you earn before taxes).
For example, if your monthly bills are $3,000 and your gross monthly income is $9,000, your DTI is 33%. (The calculation is: $3,000 ÷ $9,000 = 0.33).
credit score
Lenders will perform a credit check, and most lenders will look for a FICO® score in the 620-700 range. You may still be approved for a loan with a low credit score, but your interest rate may be higher.
What is the difference between a home equity loan and a HELOC?
It's easy to confuse a home equity loan and a home equity line of credit (HELOC), but they are not the same. The differences between them are as follows:
payment
With a home equity loan, you get the money all at once. Then, start making equal monthly payments until it's paid off.
When you get a HELOC, you can borrow up to your credit limit, pay it off, and borrow more for the first few years (like a credit card). This is called the draw period and can last from 5 to 10 years. Once the drawing period ends, the repayment period begins.
payment
Home equity loans typically come with a fixed interest rate and fixed monthly payments.
Most HELOCs have variable interest rates. This means that your interest rate and required payments can change depending on your economic situation. Some HELOCs have a floating rate until the end of the drawing period, but a fixed rate once the repayment period begins. Another type of HELOC offers a new and sometimes different fixed interest rate each time you withdraw your funds. These are sometimes called hybrid HELOCs. While it is possible to find a fixed rate HELOC that provides a fixed interest rate from day one, it is more difficult to find.
Some HELOC lenders only require interest payments during the drawing period. In this case, the payout amount will increase rapidly once the drawing period ends. Other financial institutions require periodic principal and interest payments on the amount you withdraw, even if you are eligible to continue withdrawing more money.
How to find the best home equity loan lender
Like the best mortgage lenders, the best home equity loan lenders have a few things in common:
Low interest rate Repayment terms that fit your budget Strong customer service
When looking for a home loan, it pays to shop around. Most lenders will perform a soft credit check before making a loan offer. In contrast to hard credit checks, soft credit checks do not hurt your credit score. Lenders will perform a rigorous credit check until you decide to accept a loan offer. And even if a credit check lowers your score by a few points, the effect is only temporary.
Pros and cons of home equity loans
Like most things in life, home equity loans have their pluses and minuses. Here, we will explain the advantages and disadvantages separately.
