If you need to borrow money and you have enough equity in your home, it may be a good idea to take out a home equity loan. A home equity loan lets you borrow against the equity in your home, usually at a lower interest rate than other types of loans.
However, this type of loan product is not for everyone — it also comes with risks. Before deciding to use this loan option, make sure you understand what these risks are, what a home equity loan is and how it works.
What is a home equity loan?
A home equity loan, commonly referred to as a second mortgage, is a fixed rate, lump sum loan secured by the equity in your home. Since the loan is secured by your home, lenders generally charge lower interest rates than personal loans or credit cards.
For example, as of June 23, the average home equity loan rate was 5.36%, while the average personal loan rate was 10.49%, and the average credit card rate was 16.09%. . However, the interest rate you will receive on a home equity loan, personal loan or credit card will vary depending on your lender, your credit score, your income and other factors. If you have excellent credit, you might get a lower interest rate.
How does a mortgage loan work?
When you take out a home equity loan, a lender approves you for a loan amount based on the percentage of your home’s equity. Some lenders may require you to pay closing costs. Once your funds are issued, you must repay the loan in fixed monthly installments including principal and interest. Although terms vary, home equity loans can last up to 30 years.
Since the loan is secured by your home, it puts your home at risk if you can’t repay what you borrowed. If you default on the loan, the lender can foreclose on your home. Plus, it will cause serious damage to your credit score, making it harder for you to qualify for future loans.
If you use a home equity loan to make improvements to your home, the interest you pay may be tax deductible. According to the IRS, you can deduct interest on a home equity loan that is used to “purchase, build, or substantially improve” the home.
How to calculate the equity in your home
Home equity represents the part of your home that you actually own; this is the current value of your home minus the outstanding balance of your mortgage. To calculate your home’s equity percentage, you need to divide your outstanding mortgage balance by the appraised value of your home. If you need help estimating the value of your home or calculating your net worth, use a net worth calculator.
For example, if your outstanding mortgage balance is $100,000 and your home’s estimated value is $250,000, you have 40% of the equity in your home.
Home equity loan requirements
Although lenders have different requirements for home equity loans, you generally need a credit score of at least the mid-600s, at least 15% to 20% of your home’s equity, a solid income and a debt-to-income ratio (DTI) that is below 43 percent. Before applying for a home equity loan, review the lender’s minimum requirements to see if you qualify.
Additionally, lenders typically have a maximum combined loan-to-value ratio of up to 85%. This means that you can only borrow 85% of the value of your home, minus the outstanding balance of your mortgage. For example, if your home is worth $250,000 and you owe $100,000, 85% of your home’s value is $212,500. If you subtract your balance from this amount, you get $112,500 – that’s the maximum amount your home equity loan could reach.
Differences Between a Home Equity Loan and a Home Equity Line of Credit (HELOC)
A home equity loan isn’t your only option for borrowing against the equity in your home. You can use a home equity line of credit (HELOC) instead.
Although a HELOC is also secured by the equity in your home and has similar borrowing requirements, it works differently than a home equity loan. A HELOC is similar to a credit card in that you can borrow money as needed up to a set limit. Unlike home equity loans, HELOCs generally have variable interest rates. Although average HELOC rates tend to be lower than home equity loan rates, your monthly payments could increase if interest rates rise.
Additionally, a HELOC comes with a drawdown period and a redemption period. During the drawdown period, which typically lasts 10 years, you can borrow money from the line of credit and are responsible for paying interest only. When this period ends, the repayment period begins and you must repay the principal plus interest. During the repayment period, which often lasts 10 to 20 years, you cannot borrow money from the HELOC.
The bottom line
When deciding if taking out a home equity loan is a good idea, consider the benefits and costs. Although home equity loans generally come with lower interest rates than other types of loans, you risk losing your home if you can’t repay your loan. If you need more payment flexibility, consider choosing a HELOC instead.
However, if you decide borrowing against your home isn’t right for you, research different loan options.