What is a Home Equity Loan?
A home equity loan is a loan option that enables homeowners to borrow money based on how much equity they have built up in their home. If you are preparing to make costly home renovations or need help to pay tuition for a child or spouse, you can take out money in the form of a lump sum or as monthly allowances that are then due back to the lender within a specific time frame. Each lender offers loans with different interest rates and terms and conditions, so it’s important to understand how the loan works and to compare loan offers to see which one works best for you.
How Does A Home Equity Loan Work?
Lenders look at each borrower’s eligibility for a home equity loan based on the amount of equity that they have in their property. Home equity loans can be taken out for up to 85% of the total amount of the mortgage that has been paid off. If you have paid off $200,000 of a $275,000 home, lenders will allow you to borrow up to $150,000.
Although you’re essentially borrowing from the amount of money you’ve already paid towards your home, the home equity loan functions as an independent loan from your mortgage. It will have its own APR and conditions and is paid off as a second monthly payment in addition to your mortgage payments.
How To Get A Home Equity Loan
Getting a home equity loan requires more than equity. In order to ensure that you’ll be able to take out your loan, lenders will look for a credit score of 620 or higher and a DTI (debt-to-income ratio) of less than 43%. Ideally, you’ll want your finances to be in even better shape to get lower interest rates and fewer fees.
Having sufficient income is also important. While requirements vary by lender, most will want to make sure that you have enough money to make monthly payments.
How Long Does It Take To Get A Home Equity Loan?
It can take anywhere from 2-4 weeks after applying to close on a home equity loan. During this time period, a loan officer will look at the application, compare it with potential loan options, and might request additional documentation if they feel it’s necessary. Other steps to granting the loan might include verification from financial institutions and an assessment of your property value.
Is A Home Equity Loan A Mortgage?
A home equity loan functions like a mortgage, which means that it is taken out with your home as security. If you were to default on your loan payments, the lender would be entitled to seize your home as collateral. This allows lenders to offer home equity loans more freely but heightens the risk for the borrower.
What Are The Types Of Home Equity Loans?
There are two types of home equity loans. The first is the traditional home equity loan, which functions like a second mortgage. The second is a home equity line of credit (HELOC), which enables borrowers to use their equity in small amounts.
Home Equity Loan
The traditional home equity loan is a lump sum of cash that is taken out in one transaction and then paid back to the lender in monthly installments. In addition to an APR, the home equity loan will come with additional fees for application, underwriting, appraisal, and other factors. A home equity loan is best for one-time financial needs, like renovating a large part of your home or consolidating debt.
Home Equity Line Of Credit (HELOC)
A HELOC works like a credit card. In fact, some lenders will actually give you a credit card that charges to your HELOC account. A HELOC comes with a spending limit each month and due dates for payments. It will also come with fees in addition to the APR. Some lenders charge a participation fee, which is due whether or not you use your account. Others charge a transaction fee. It’s important to carefully read all materials provided by the lender to understand what fees apply and when they are due.
Choosing a home equity loan vs. a home equity line of credit depends largely on what you want to use the loan for. A traditional home equity loan works well if you need a large sum of money for a tuition payment or an invoice for a contractor. If, on the other hand, your financial needs occur in smaller amounts or overtime, the HELOC might be your best option.
What Are The Benefits Of A Home Equity Loan?
A home equity loan has several great benefits:
- Financial flexibility: The potential to take out a large amount of money with the home equity loan can help with any number of financial needs, whether to cover for home improvements or to pay off a vehicle and consolidate debt.
- Lower interest rates: Because the borrower’s home is used as collateral, home equity interest rates typically fall lower than rates on a traditional credit loan.
- Potential tax benefits: If you’re using your home equity loan for renovations, you might also qualify for tax deductions on the interest of the loan.
What Is The Downside Of A Home Equity Loan?
It’s important to understand the risks that come with a home equity loan. Here are some downsides to take into consideration:
- Additional payments: While the home equity loans and HELOC allow you to borrow money upfront, that amount will have to be paid back in monthly installments on top of your mortgage and other monthly amounts.
- Other fees: Home equity loans come with various closing costs and fees that can add up to a considerable amount of money. Additionally, many loan agreements contain payment requirements that you will have to follow throughout the lifetime of the home equity loan, such as interest rate adjustments and membership fees.
- Risk of foreclosure: If you are unable to make payments on your home equity loan, your lender will be able to seize your home as collateral. While this enables the borrower to take out a larger loan with a lower interest rate, it increases the risk of losing everything if payments can’t be made.
Taking out a Home Equity Loan
A home equity loan allows you to borrow the money you’ve already put into your home, and it’s a great option for big expenses that come with home improvements, travel, or other financial needs. Using a home as collateral lowers the risk to the lender, and they can offer larger loan amounts and lower interest rates to borrowers.
However, the risk of defaulting on payments and losing your home is serious. It’s important to fully understand your financial situation and what amount of monthly payments you can tolerate before signing on to a home equity loan. If you will be able to pay off the loan without financial stress, the home equity loan is a great opportunity to use the money you’ve already put towards your property for future financial needs.
This page last updated: March 29, 2022
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