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How to Get a Home Equity Loan
By Victor Rosario MONEY RESEARCH COLLECTIVE
A home equity loan can be an excellent way for homeowners to quickly access cash for large or unexpected expenses. However, depending on the balance on your first mortgage, it could become a financial burden. Moreover, home equity loans come with the same risks associated with first mortgages. Since even the best home equity loans have potential benefits and downsides, understanding how these products work before getting one can be essential to your financial health.
What is a home equity loan?
Home equity loans use your home as collateral, allowing you to convert the equity you have in your home into cash. This type of loan provides borrowers a lump sum they can use to cover a large expense, such as paying down consolidated credit card debt. However, as the home is used as collateral, the loan puts a second lien on the property. Failing to meet your monthly payment, then, can put the home at risk of foreclosure.
Requirements for a home equity loan
The requirements for a home equity loan vary by lender, but generally include having a certain percentage of equity in your home, a good credit score and a low debt-to-income ratio, as well as a reliable source of monthly income. Lenders also look at your payment and credit history as reflected in your credit report in order to assess your creditworthiness.
Let’s look at these factors in more detail:
- Home equity – The amount of money you can borrow from a home equity loan is partly based on the amount of equity in your home — the appraised value of your house minus the remaining loan balance on your existing mortgage. Lenders may allow you to borrow up to 85% of your home equity through a home equity loan, but you need to have accrued at least 20% equity to qualify.
- Loan-to-value (LTV) ratio – The value of your home against your mortgage balance is generally expressed as a percentage known as the loan-to-value ratio (LTV). And most lenders require an LTV below 85%.
- Debt-to-income (DTI) ratio – Your DTI ratio compares your monthly debt obligations against your monthly income. Lenders typically require a DTI ratio of under 45%.
- Credit score – While minimum credit score requirements vary by lender, most lenders require a score of 620 or above.
- Income – To obtain any type of home loan, lenders need to verify you have sufficient income. Requirements may vary, but you’ll typically need to provide tax returns, pay stubs and bank statements.
Pros and cons of a home equity loan
- Home equity loan rates are usually lower than credit card and personal loan rates
- Interest paid on a home equity loan may be tax deductible if the loan was used for home improvements
- Provide a lump sum that can be used for any purpose, including consolidating high-interest debt
- Home equity loan payments added to your current mortgage payments may cause financial strain
- You could lose your home to foreclosure if you do not meet your monthly payments
- You have to pay closing costs upfront, which would include origination fees, appraisal fees and underwriting fees, among others
How does a home equity loan work?
Home equity loans are also known as second mortgages because they use your home as collateral. These loans work similarly to installment or personal loans, and provide borrowers a lump sum they can use for any purpose.
Since your home is used as collateral, interest rates on home equity loans tend to be lower than personal loan rates. They also feature fixed interest rates, which make for predictable monthly payments, and loan terms that range from five to 30 years. Unlike with personal loans, however, failing to make your monthly loan payments could result in you losing your home.
Two other loan options that allow borrowers to tap into their home equity are home equity lines of credit (HELOCs) and cash-out refinance loans. HELOCs allow homeowners to tap equity in their home through a line of credit from which they can draw and repay as needed, during a predetermined draw period.
Once the draw period is over, the line of credit enters a repayment period during which the borrower can’t use the funds and has to repay any outstanding balances plus interest. HELOCs generally feature variable interest rates, so payments can increase or decrease from month to month. Nevertheless, HELOCs can be a good option for those working on ongoing home improvement projects or who have variable but recurring expenses.
Cash-out refinance loans are different from home equity loans and HELOCs in that instead of adding a second lien on your home they replace your original mortgage with a larger loan amount – at prevailing mortgage rates. Like home equity loans and HELOCs, the maximum you can borrow through a cash-out refinance loan will partly depend on how much of your mortgage you have paid off and the current market value of your home.
What is the process of getting a home equity loan?
Most lenders now allow borrowers to apply for a home equity loan or line of credit entirely online. Before making a decision, make sure to:
- Check your credit score and credit reports to ensure you meet your lender’s credit requirements. Work on improving your credit score if necessary.
- Verify that you have sufficient home equity to qualify for this type of financing.
- Understand the different loan options available, including grasping the difference between variable interest rates and fixed interest rates.
- Use a loan calculator to help you choose a loan amount that works for your financial situation.
- Shop for quotes from different lenders to get the lowest possible interest rate on your loan and pay less on closing costs.
How to get a home equity loan FAQs
How long does it take to get a home equity loan?
Although it varies, getting a home equity loan typically takes between two and eight weeks. To speed up the process, gather all the necessary documentation before applying.
What kind of credit score do you need for a home equity loan?
Banks and credit unions that offer home equity loans usually require credit scores in the fair to excellent range. While some lenders accept FICO credit scores as low as 620, a 670 score or above will improve your chances of qualifying.
How much money can you borrow through a home equity loan?
Lenders typically allow homeowners to borrow between 80% and 85% of the equity in their homes. Of course, the actual loan amount will depend on a number of factors, including your credit score, income and debt-to-income ratio, among others.
Summary of our guide of how to get a home equity loan
Home equity loans allow homeowners to access as much as 80% or 85% of the equity in their home as a lump sum. While this type of loan can help borrowers consolidate debt, pay for home renovations and cover other large, one-time expenses, they essentially add a second lien on the property. This means that failing to pay back the loan can put the borrower’s home at risk of foreclosure.
Those looking to tap into their home equity through a home equity loan will have to meet their lender’s credit, income and debt requirements. They must also have sufficient tappable equity in their home. As part of the loan process, borrowers should get quotes from several lenders to get the best possible deal on their home equity loan.
