A home equity loan can allow you to access large sums of money without selling your home. Using your home as collateral, you can get a loan to finance anything you want or need — the choice is up to you.
There is a bit you should know before jumping all in. Any time a loan requires collateral, it’s always best to read the fine print. Keep reading to learn more about the details and see if a home equity loan is right for you.
What is a home equity loan?
Let’s start off by explaining what equity is. Equity is the amount of your home’s value that you own beyond your mortgage.
In other words, it’s what you could sell your house for right now, minus what you still owe on your mortgage. If your current mortgage is $150,000 but the house appraises for $285,000 then you would have $135,000 in equity.
A home equity loan is then a loan where you, the homeowner, use the equity of the home as collateral for the loan.
But here’s the catch.
Just because you have $135,000 in equity doesn’t mean that is what is available to you from the bank. Lenders typically only approve home equity loans for up to 80% of the home’s value. So in this example, the lendable value of the home is $228,000. When you subtract your $150,000 mortgage, that leaves you with $78,000 available to you via a home equity loan.
Of course, there are other variables the lender considers as well.
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Do you automatically qualify for a loan if you have equity in your home?
Home equity loans used to be a sure thing. Just about any homeowner could walk into a bank and take out a loan if they had equity in their house.
Then the 2007 housing crisis happened, and everything changed.
Now lenders are pickier and comb through every detail of each application. They have also started limiting the loan amount to only 80% of your home’s value, whereas 90% to 100% used to be commonplace.
Before approval, you’ll also obviously need to be able to demonstrate and provide proof that you can repay the loan. If your argument is that you have immediate plans to sell after any type of renovation has been done, prepare to be disappointed. Plans alone won’t suffice. A secure and constant revenue stream is definitely needed.
Most lenders require a debt to income ratio of 43% or less. So the monthly payment for your loan, in conjunction with your other monthly debt payments, can’t exceed 43% of your monthly pre-tax pay. Depending on your finances, this could limit just how much of your equity you’re able to tap into.
Is a home equity loan the same thing as a home improvement loan?
No, they are very different. You could use a home equity loan to finance needed repairs or home improvements, but you could not use the funds from a home improvement loan as you would a personal loan.
A home improvement loan also doesn’t take into account any type of equity you have in your home, nor does it require any kind of collateral. You use it for anything that revolves around the “improvement” of your home — be it to install a swimming pool, remodel a kitchen, or repair a roof.
Lenders usually require you to provide a detailed plan of what you would use the money for, and the repayment periods are a lot shorter than home equity loans.
Is a home equity loan the same as taking out a second mortgage?
Generally speaking, yes. People tend to confuse home equity loans with home equity lines of credit. A home equity line of credit (HELOC) is an adjustable-rate loan and can be a second mortgage, but it doesn’t have to be.
You can get a HELOC after you’ve paid off your mortgage, in which case the HELOC would be your first mortgage. Rather than receiving a single payment as you would with a home equity loan, a HELOC lets you draw from an account as you need funds.
There are quite a few benefits associated with home equity loans for both the borrower and the lender.
From the buyer’s side:
For starters, if you have bad credit, home equity loans tend to be easier to get than other types of loans. So if you’re getting turned down by multiple lenders, it’s a great alternative to traditional personal loans.
Secondly, most home equity loans have lower interest rates than unsecured loans, which will help you pay less over time. And you can use the funds to pay off credit card debt with higher interest.
Your credit score will directly affect the interest rate you get. The higher your score, the lower your interest rate will be.
Plus, there are some tax advantages. Not everybody qualifies, but if you do, all of the interest you pay is tax-deductible. That means you’ll pay less taxes come April. Lastly, if you have a fair amount of equity in your home, you can borrow against the equity.
And for the lenders:
Home equity loans are safe loans to make for a bank because the loan is secured by the homeowner’s house. If the homeowner fails to make payments, the lender can seize the home to recoup the funds they’ve lost (which is how some of those blue foreclosure dots end up on Zillow).
Borrowers are always more likely to make a monthly payment on a loan if that loan is secured by something valuable. Most of the time they’ll choose to miss a credit card payment over a loan payment if they have to make a choice.
The main con is the most obvious one: you could lose your home if you’re unable to make payments. Many times we’re put between a rock and a hard place.
If it’s a real possibility you would be unable to pay both your mortgage and equity loan at some point in the future, this loan may not be the best for you. The interest rate will generally be higher, but there are unsecured installment loans out there that might be a better fit.
Another thing you should know is that the home equity loan market is rife with scammers. Though technically legal, some lenders may seize upon any opportunity to rid you of your home the first chance they get. So if the company that’s caught your eye seems too good to be true, it most likely is.
How do you receive your money?
It works in a couple of different ways. You can either receive money as a lump sum or line of credit.
Get all of your cash at once and begin paying back the loan with monthly payments. You can choose to have either a fixed or variable interest rate. Each payment you make will go towards interest and the principal.
Line of Credit
Once you are approved for a line of credit, you can choose to only borrow what you need when you need it, much as you would a credit card.
Referred to as a HELOC (home equity line of credit), if you go this route you can borrow multiple times and only have to make smaller payments as you do. You can actually do this for several years until you’re expected to start making larger payments to pay off the loan.
Going the line of credit route is considered by many to be the best option because of its flexibility. You’re only expected to pay interest on the loan amount you’ve used in the beginning. However, the interest rates are variable, meaning they can change over time, so some payments may be higher or lower than others.
Another downside to the line of credit option is that if banks need to, they can cancel the line of credit before you’ve even gotten a chance to use it. If it happens to you, pay off whatever you need to pay off and go somewhere else. There are lenders everywhere.
It’s always wise to shop around before settling with a lender. Interest rates can often vary significantly, and some lenders are more reputable than others. Moreover, many lenders require you to pay closing costs when taking out a home equity loan, but there are many that won’t.
Do your homework and calculate which one will save you the most money over time. A company may charge you closing costs, but if their mortgage rates are a lot lower than everyone else’s, they may be the best choice.
If you take out a home equity loan with a fixed interest rate, you’ll have fixed monthly payments to make each month until the loan is paid off.
If you take out a home equity line of credit, you’ll only have to pay the interest each month on what you’ve drawn. The draw period can last only a few years or up to ten years (depending on the lender). Once the draw period is over, your payments become regular payments, so each month’s payments will go towards both the interest and principal.
It is possible to pay off either type of loan early, but, once again, depending on the lender, there may be fees involved.
Can you sell your home if you get a home equity loan?
Yes, you can. It’s considered a lien on your house, so it’s settled at closing. Your loan is added to whatever you still owe on your mortgage. The sum of both is subtracted from whatever you sold your house for, with the remaining profits going to you (and, of course, Realtor fees).
Problems arise if the housing market collapses after you’ve taken out a home equity loan and the value of your home tanks. If you sell your house in this situation, what you make on your house will unlikely pay for what you still owe.
Banks don’t like giving out loans to buyers for houses with liens because they represent a greater risk for them. So if you do plan on selling your home in the near future, make sure you can pay off the loan either through the sales proceeds or other means like cash savings.
Does a home equity loan affect my credit?
Yes, it will. As with any type of loan, it can both help and hurt your credit score in various ways. Any improvement you see on your credit score should only be modest — unless, of course, you take out a large loan and spend years and years making on-time payments.
The plus side
- Make your payments on time, and your Payment History category will get a boost.
- If you get a HELOC, you’ll get a bump in the Debts Owed category because you’ll have more credit available to you.
- No matter whether you choose a lump sum or line of credit, you should see a bump in Types of Credit.
- Depending on how long it takes you to pay back the loan, if it’s for more than a few years, you’ll see a bump in Length of Credit History.
The negative side
- If you don’t make those payments on time, your score will lower via dings on your Payment History.
- If you take out a large amount, your Balances Owed category could cause your credit score to go down a few points.
- Because it’s simply a new line of credit, your score will also lower due to the New Credit category.