What is a Home Equity Loan?
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How Does a Home Equity Loan Work?
A home equity loan is secured by the borrower’s equity on their home. However, like a mortgage, the lender can foreclose on the borrower’s home if the borrower defaults on the loan.
A home equity loan is one of the two debt instruments that use home equity as collateral, the other being a home equity line of credit (HELOC).
In general, home equity loans have a fixed interest rate, requiring a borrower to make equal monthly payments over the course of the loan until it is completely paid off. This makes home equity loans much easier to integrate into a budget plan than a HELOC, because the rate and payments of a HELOC can change over the loan term.
Home Equity Loans vs. HELOCs
Both home equity loans and HELOCs allow borrowers to leverage their home’s equity to finance anything they want. While both types of loans are used for similar reasons, they are distinctly different.
A home equity loan is a lump sum that a borrower receives at once and has to repay with a fixed interest rate over a certain period. Monthly payments remain the same throughout the entire duration of the loan.
HELOCs, on the other hand, work just like a credit card. A borrower can withdraw the money from their line of credit balance as needed, and they are only charged interest on the amount they take. However, unlike home equity loans, HELOC interest rates may adjust from time to time, making payments less predictable for the borrower.
Calculating the Loanable Amount
Borrowers can typically borrow 80% to 90% of their home’s value. Calculating their loan-to-value ratio helps them determine how much they can obtain from a home equity loan.
Look at this example where a borrower’s home is worth $250,000, their mortgage balance is $100,000, and the lender allows a loan of up to 80% of the home’s value. Here is a formula to find the loanable amount:
STEP 1: Getting the Loan-to-Value Ratio
Total home value x percentage of loanable value = maximum amount of equity a borrower can borrow
STEP 2: Determining the Actual Loanable Amount
Maximum amount of equity a borrower can borrow x remaining mortgage balance = total loanable amount
The lender will multiply the borrower’s home’s value by 80%, giving the borrower a maximum of $200,000 in value that could be borrowed. Next, the lender will then subtract the balance on the borrower’s mortgage from it to get the approximate amount that can be used as a home equity loan. In this case, the actual amount is $100,000.
How to Qualify for a Home Equity Loan
Getting approved for a home equity loan is similar to a mortgage. The lender will review the application, together with the borrower’s credit score and report, debt-to-income (DTI) ratio, income, and equity on their home.
While there are no uniform approval criteria among lenders in general, a borrower will typically need the following to qualify for a home equity loan:
- Credit score – A borrower needs a credit score of 620 or higher to qualify for most home equity loans. Note that the higher the score, the more favorable the interest rate should be. Although a borrower can sometimes be granted a loan even if their score is slightly below 620, they could risk having a much higher interest rate.
- DTI ratio – refers to the percentage of a person’s monthly income that goes to debt, such as mortgages, student loans, vehicle purchases, and credit cards. To qualify for a home equity loan, the borrower’s DTI ratio must not exceed 43%.
- Actual home equity – Generally, a borrower must have at least 15% equity on their home. For example, if the house is worth $250,000 and the borrower owes $200,000 in a mortgage, the home equity is 20% ($50,000).
Where to Apply for a Home Equity Loan
Many lenders offer home equity loans—banks, credit unions, online lenders, and other financial institutions. When applying, a borrower must solicit different quotes and compare the terms, particularly the interest rate and additional fees, to find the right loan for the situation.
Most people planning to get a home equity loan start with their trusted bank. Some banks even require that a loan applicant has an account with them to get an equity loan in return for lower interest rates.
When to Consider a Home Equity Loan
A home equity loan can be a decent choice if the borrower needs the full amount at once but payable in fixed monthly payments. For instance, a borrower can use a home equity loan to combine credit card accounts into a single loan or pay a contractor upfront for a major renovation project.
A home equity loan’s flexibility makes it ideal for financing big expenses, such as home improvement projects, medical bills, vehicle purchases, or college tuition. Here are specific examples:
Home renovations, additions, and repairs are some of the most common uses for home equity loans. For many people, it is as simple as pulling money from the home’s equity and reinvesting it back into their property.
Medical procedures can put a lot of financial stress on families, especially when they have insufficient health insurance coverage. A home equity loan can help finance medical expenses and other miscellaneous costs.
Retirement Portfolio Balancing
An individual’s investment portfolio may encounter some volatility in retirement. When this happens, a retiree can take out an equity loan and draw upon it for income, allowing the retirement portfolio more time to grow. Doing so can minimize the risk of exhausting the entirety of the retirement fund.
Consolidation of Debt
Bills incurred from credit cards, student loans, and other personal debt can be overwhelming, and some individuals may find it easier to pay them off using a home equity loan. In some instances, this can be the most efficient option as interest rates for home equity loans are often lower than other types of personal loans, such as credit cards.
Pros and Cons of a Home Equity Loan
As with all types of loans, home equity loans have their share of advantages and disadvantages.
- Fixed payment terms – Home equity loans usually have predetermined payment terms, ranging from five to 30 years, as well as fixed monthly payments and interest rates. As such, borrowers know precisely how much they will have to pay every month and when the loan will be paid off.
- Low interest rates – Because they provide security to lenders in terms of collateral, home equity loans typically have lower interest rates than other types of loans, such as credit card loans and personal loans.
- Flexibility in usage – Home equity lenders usually have no restrictions on how the funds will be used.
- Home foreclosure risk – A home equity loan is secured by the borrower’s home. If the loan is not repaid, the lender could foreclose on the property.
- Closing fees – Home equity loans are similar to mortgages in terms of closing costs and fees. While these can sometimes be waived, they can end up rolling into the amount of the loan itself, adding to its total cost. Fees vary from lender to lender, but these will usually be between 2% to 5% of the total loan amount.
Considerations Before Applying for a Home Equity Loan
Getting a home equity loan is not something to take lightly, but it can be a monetary lifeline in specific scenarios. Many borrowers use the money they get by investing in home improvement to increase their property value or repair damaged components. However, there are other ways to use a home equity loan thanks to its flexibility.
In addition, the interest on a home equity loan is not tax-deductible if the loan is used for purposes other than remodeling or renovating the home used as collateral.
Finally, borrowers must prepare for additional costs and fees. The following are some of these potential closing expenses:
- Appraisal fees – Lenders often charge a fee for a home appraisal, which is a third-party assessment of how much a borrower’s house is actually worth.
- Origination fees – Some lenders will charge a fee to issue a loan. This is referred to as an origination fee.
- Preparation fees – Some lenders will also charge preparation fees for preparing and compiling loan documents and dealing with notaries and lawyers.
- Title search fees – With these fees, lenders can do a title search of a person’s home and search for liens and other factors related to the title.
A home equity loan is a lump sum loan that allows the borrower to leverage the equity in their home, while simultaneously putting up their home as collateral for the loan. This type of loan can be used for a variety of purposes, such as home improvement and debt consolidation. However, it also acts like a second mortgage, which allows the lender to foreclose on the borrower’s property if the borrower defaults or fails to satisfy the terms of the loan. In fact, lenders also look at almost the exact same criteria for a home equity loan as when they review a new mortgage application.
Home equity loans are often compared with HELOCs, as they are the only two debt instruments that use equity as collateral, although they have subtle differences. The former works best for borrowers who want to cover a large expense and the idea of predictability due to its fixed terms. On the other hand, the latter is ideal for people who need access to additional funds now and then and do not want to apply for a new loan every time they need it.
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