A home equity loan allows homeowners to leverage the equity in their home to access a large lump sum of cash. Also referred to as a second mortgage, home equity loans can provide funds for major expenses like home renovations, debt consolidation, college tuition, and more.
But before taking out a home equity loan, it’s important to understand how they work, their pros and cons, and alternatives that may better suit your needs. This comprehensive guide will explain everything you need to know about home equity loans.
What is Home Equity?
Home equity represents the current value of your home minus any mortgage debt owed on it. For example, if your home is worth $300,000 and you owe $180,000 on your mortgage, your equity is $120,000 ($300,000 – $180,000).
Home equity builds over time as you pay down your mortgage principal and as your home appreciates in value. You can tap into this equity as a source of financing by taking out a home equity loan or home equity line of credit (HELOC).
How Do Home Equity Loans Work?
A home equity loan provides a lump sum of cash upfront, which you pay back in fixed monthly installments over a set repayment term, usually between 10-30 years. It works similarly to how you pay back your primary mortgage.
Here are some key features of home equity loans:
- Fixed interest rate – The interest rate is fixed for the life of the loan, meaning your monthly payments do not fluctuate.
- Fixed monthly payments – Your monthly principal and interest payments stay the same over the loan term.
- Set repayment term – Repayment terms are usually between 10-30 years. Longer terms have lower monthly payments but higher total interest costs.
- Loan amount – The amount you can borrow depends on how much equity you have, typically up to 85% of your equity.
- Collateral – Your home serves as collateral for the loan. If you default, the lender can foreclose and take possession of your home.
- Use of funds – Home equity loan funds can be used for any purpose, unlike a primary mortgage.
- Closing costs – Expect to pay 2-5% of the loan amount in origination fees and closing costs.
- Tax deductibility – Interest is only tax deductible if funds are used for home improvements, not other expenses.
READ ALSO: Home Equity Line of Credit: A Comprehensive Guide to HELOCs
Home Equity Loan Requirements
Here are typical eligibility requirements to qualify for a home equity loan:
- Credit score – Most lenders require a credit score of at least 620, but scores of 700+ get better rates.
- Loan-to-value (LTV) ratio – The combined loan amounts usually cannot exceed 80-85% of your home’s value.
- Debt-to-income (DTI) ratio – Your total monthly debt payments, including the new home equity loan, should be less than 43% of your gross monthly income.
- Equity – You need at least 15-20% equity built up in your home to qualify.
- Employment – Stable income and at least 2 years of employment is usually required.
Requirements can vary by lender, so check specific criteria before applying. Also, the higher your credit score and equity stake, the better the rate you can qualify for.
How Much Can You Borrow?
The amount you can borrow depends on:
- How much home equity you have – Lenders will typically let you borrow up to 85% of your available equity.
- Your DTI ratio – Debt obligations cannot exceed 43% of your income, limiting your borrowing power.
- Your credit score – Just because you qualify for a certain amount doesn’t mean you’ll get approved for that much based on your creditworthiness.
Use the loan amount calculator below to estimate your potential borrowing power based on these factors:
- Home Value: $300,000
- Mortgage Balance: $180,000
- Equity (Value – Mortgage): $120,000
- Max Loan at 85% Equity: $102,000
Pros of Home Equity Loans
There are several potential benefits that make a home equity loan worth considering:
Lower interest rate – Interest rates on home equity loans are generally lower than rates for credit cards, personal loans, and other forms of unsecured debt. This can save substantially on interest expenses.
Fixed payments – Having fixed loan payments can make budgeting easier. Your monthly amount due does not change over the loan term.
Long repayment terms – Extended repayment terms of up to 30 years give you more time to pay off the loan and lower each monthly payment.
Accessible funds – The lump sum distribution provides immediate access to cash that can be used for any purpose.
Consolidate high-interest debt – It may allow you to consolidate and pay off credit card, auto loan, or other unsecured debts at a lower single rate.
Home improvements – Funds can be used tax-free for renovations and repairs that increase the property value.
Cons of Home Equity Loans
Some drawbacks to weigh include:
Closing costs – You’ll pay 2-5% of the loan amount in origination and closing costs. This can add up to thousands in upfront fees.
Risk of foreclosure – Not paying back the loan could result in foreclosure and loss of your home.
No flexibility – The set lump sum distribution cannot be changed after closing. You may borrow too much or too little.
Lengthy process – Home equity loans can have extensive paperwork, underwriting, and closing timelines.
Variable options lack payment stability – Home equity lines of credit (HELOCs) come with fluctuating monthly payments.
Interest not always deductible – Only interest for home improvements is tax deductible now, not interest for other uses.
Alternatives to Home Equity Loans
Depending on your purpose and financial situation, here are some alternatives to consider:
401(k) or IRA loans – For homeowners needing cash in a pinch, borrowing against retirement savings may provide tax-advantaged and low-interest funds.
Refinancing – If your goal is to lower your mortgage rate or monthly payments, refinancing your primary home loan may be a better option than taking out a second loan.
HELOC – Home equity lines of credit offer flexible borrowing and potentially lower variable rates. But payments fluctuate, so it carries some risk.
Cash-out refinance – This converts equity into cash like a home equity loan, but folds it into a new first mortgage with potentially better terms.
Personal loans – Unsecured personal loans don’t put your home at risk. But they have higher rates and smaller loan amounts.
Credit cards – Balance transfer or 0% APR cards allow consolidated debt payoff over time. But balances must be repaid before the intro period ends.
When to Get a Home Equity Loan
Some situations when a home equity loan may be advantageous include:
- Large home renovation projects
- Unexpected emergency expenses
- Medical bills not covered by insurance
- College tuition
- Debt consolidation at a lower rate
- Business financing needs
However, carefully consider both your ability to repay the new loan and also how it fits within your broader financial plan and goals.
When to Avoid a Home Equity Loan
Scenarios where a home equity loan is risky or ill-advised:
- If you are currently struggling to make mortgage payments
- To pay off credit card debt you will likely accrue again quickly
- To finance a luxury or unnecessary expenditure
- If you are close to retirement age
- If you have significant volatility in your income
In these cases, the risk of foreclosure, burdensome payments, or other alternatives likely is a better choice.
Pros and Cons Summary
Pros of Home Equity Loans:
- Lower interest rates
- Fixed monthly payments
- Access to lump sum cash
- Allows debt consolidation
- Home improvement tax deduction
Cons of Home Equity Loans:
- Closing costs and fees
- Risk of foreclosure
- Inflexible lump sum
- Lengthy application process
- Interest not always deductible
Alternatives to Home Equity Loans
If a home equity loan does not seem like the right fit, here are a few other options to consider instead:
Refinancing – Taking out a new primary mortgage at today’s lower rates.
HELOC – A revolving line of credit with flexible draws but variable rates.
401(k) loan – Borrowing against your retirement plan assets.
Personal loan – An unsecured installment loan from an online lender.
Credit cards – Zero-percent balance transfer cards allow consolidated payoff over time.
Cash-out refinance – Folding your equity withdrawal into a new first mortgage loan.
Each alternative has unique pros, cons, rates, and qualifications to weigh based on your specific situation and financial needs.
FAQs About Home Equity Loans
What credit score is needed for a home equity loan?
Most lenders require a minimum credit score between 620-640 to qualify for a home equity loan. But borrowers with scores of 700+ will get approved for larger loans with better rates.
How much does a home equity loan cost?
Closing costs for home equity loans average 2-5% of the total loan amount. This covers origination fees, appraisal fees, title fees, and other processing charges to open the loan.
Are home equity loan rates fixed or variable?
Home equity loans have fixed interest rates that remain the same over the full repayment term. HELOCs have variable rates that can fluctuate up or down periodically.
Can you get denied for a home equity loan?
Yes, you can get denied if you have significant debts, a low credit score, a high loan-to-value ratio on your home, or a limited income and employment history. Lenders want to confirm you can repay the loan.
How long does it take to get a home equity loan?
The entire application and approval process usually takes between 2-6 weeks. It requires paperwork, an appraisal, a title search, and full underwriting, just like with a primary mortgage.
Can you deduct home equity loan interest?
You can only deduct interest on a home equity loan if the funds get used for home improvements or renovations, up to certain IRS limits. Interest is not deductible when used for other expenses.
Do home equity loans affect your credit score?
Yes, just like any loan, a home equity loan can impact your credit score in a few ways. It can lower your score initially when you take on the debt, but improve it over time by having an additional open account and making consistent payments.
The Bottom Line
Home equity loans allow homeowners to leverage one of their largest assets, their home equity, to access a sizable lump sum for major expenses and financial needs. But it is secured debt that puts your home at risk if you default.
Compare home equity loans to alternatives like HELOCs, cash-out refinancing, or unsecured loan options. Get clear on your borrowing needs and research rates and terms to find the most affordable financing method for your situation. Use any borrowed funds judiciously, and be sure you have the means to repay the home equity loan on schedule.
A home equity loan can provide homeowners with a powerful source of financing in the form of a sizable lump sum distribution. The funds can be used for just about any purpose. Homeowners should carefully weigh the pros and cons before moving forward with a home equity loan.
While the interest rate is typically lower compared to other consumer debt products, the fact that your home secures the debt means it is at risk if you cannot repay the loan. Be conservative when estimating your borrowing needs, and practice discipline when using the funds to avoid financial hardship down the road.
Consider alternatives like tapping retirement accounts, balance transfer credit cards, or personal loans if possible. Get professional financial guidance if needed. But for large, necessary expenses a home equity loan may offer competitive rates and reasonable payment terms. Just be diligent in crunching the numbers, assessing your budget, and understanding the fine print before signing on the dotted line.
