What is a home equity loan?
A home equity loan is secured by the equity in your home. If you don’t repay the loan as promised, the lender can repossess your home (the collateral), sell the property and recoup the loss.
One difference between a home equity loan and other types of loans is that if the funds are used to make renovations or additions to your home, you may be able to deduct the interest.
To note: Before applying for a home equity loan, plan what you will do if you run into a financial problem like an unexpected illness or job loss. Because your home is on the line, it pays to have an emergency fund that ensures payments will be made no matter what.
How does a mortgage loan work?
When you take out a home equity loan, the funds are dispersed in a lump sum and repaid in monthly installments. A home equity loan can be used for just about anything, including travel, a wedding, or debt consolidation. The interest rate and monthly payments are fixed, making it easy to budget with confidence. The APR is generally lower on a home equity loan than on an unsecured personal loan because the lender has collateral protecting their interests.
Loan terms for most home equity loans range from five to 20 years, although they can extend up to 30 years. There are no upfront costs or closing costs with home equity loans, although some lenders charge a fee.
How much can I borrow?
The first requirement is that you have enough equity in your home to borrow. Lenders generally require borrowers to have at least 20% of their home’s value in equity. To find out how much equity you have, the lender orders an appraisal of the home. The cost of the home appraisal is added to the fees you pay at closing.
Let’s say your home is appraised at $350,000 and you have a mortgage balance of $200,000. This means you have $150,000 in equity. The next step is to determine how much of this capital you can borrow. Most lenders allow you to borrow up to 85% of the available capital. So if you have $150,000 in equity, the maximum amount you could borrow would be $127,500 (150,000 x 0.85 = 127,500).
Requirements for a home equity loan
To qualify for a home equity loan, you will need to provide your lender with a series of documents, including:
- W2 or 1099 income statements for the last two years
- Bank statements for three months
- Federal income tax returns for two years
- Recent payslips
- Proof of other sources of income like social security payments or tips
- Proof of investment income
A lender will also verify your:
Debt-to-income ratio (DTI)
To qualify, your DTI generally cannot be higher than 43%. To calculate your DTI, add up your monthly payments (for fixed expenses, such as mortgage, car loan, child support, credit card payments, and other loan payments). Once you get that total, divide the number by your monthly gross income (the amount you earn before taxes).
For example, if your monthly bills are $3,000 and your monthly gross income is $9,000, your DTI is 33%. (The calculation looks like this: $3,000 ÷ $9,000 = 0.33).
A lender will perform a credit check, with most lenders looking for a FICO® score of at least 680. Although you may be approved for a loan with a lower credit score, the interest rate is likely to be higher. raised.
What is the difference between a home equity loan and HELOC?
It’s easy to confuse a home equity loan with a home equity line of credit (HELOC), but they’re very different lending products. Here’s how they differ:
A home equity loan is disbursed in a lump sum, while funds can be withdrawn from a HELOC as needed. Similar to how a credit card works, once you repay funds borrowed from a HELOC, the money is available to be borrowed again.
A home equity loan has a fixed interest rate and a fixed monthly payment, while a HELOC has a variable interest rate and variable minimum monthly payments. Once a home equity loan is disbursed, the entire loan must be repaid over time. With a HELOC, you only pay back the funds you withdraw, plus interest.
How to find the best home equity lenders
Like the best mortgage lenders, the best home equity lenders have several things in common, including:
- Low interest rate
- Repayment methods adapted to your budget
- Solid customer service
It pays to shop around when you’re looking for a home equity loan. Most lenders do a soft credit check before making a loan offer. Unlike a hard credit check, a soft check does not affect your credit score. It is only when you decide to accept a loan offer that the lender does a thorough credit check. And even if the credit check knocks your score down a few points, you can count on it to bounce back after a few one-time payments.
Advantages and disadvantages of home equity loans
Like most things in life, home equity loans have their pros and cons. Here we break down the pros and cons.