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What Is a Home Equity Loan?

It’s estimated that American homeowners could spend $430 billion on home improvements and repairs in 2022. For many homeowners, it’s possible they’re getting the money for these projects through a home equity loan. A home equity loan is a way to tap into the part of your home you’ve already paid off.

But how does a home equity loan work? Learn more about the ins and outs of home equity loans so you can determine if they’re the right financial move for you.

Understanding Home Equity

Home equity is the the difference between what your home is worth and how much you owe on the home. When you first bought your home, you likely established a solid amount of equity with your down payment. With each monthly mortgage payment you make, you increase your equity in your home even further.

When you’re at the beginning of your mortgage, most of your monthly payments go towards interest instead of your principal. However, as you continue making payments, the balance switches in your favor. The more of your loan you pay off, the more equity you build by paying down the principal. When you finally pay off your loan, you have 100% equity — meaning you fully own the home.

Determining your equity also depends on your home’s market value. Your equity can rise or fall as your home’s market value changes. For example, if your home increases in value, the amount of equity you can borrow from for a home equity loan also increases. 

How is Home Equity Calculated?

Calculating your equity boils down to a math equation. Take the amount you still owe on your mortgage and subtract it from your home’s estimated value. As an example, say you have $150,000 left to pay on a home that originally costs $500,000. You would have $350,000 worth of equity in the home, or 70% equity.

While you can use your original purchase price, to get a more accurate calculation, you may want to order a home appraisal. This is where a professional comes and offers an up-to-date estimation of your home’s value.

How to Build Your Home’s Equity

Building up equity can give you access to more capital with a home equity loan. Here are a few things you can try:

  • Make additional mortgage payments. If you do not have that much extra cash on hand, consider switching to biweekly payments where you split your monthly premium in half. This gives you one extra payment over the course of a year.
  • Consider home improvements. These build equity because they can increase the value of your home. The highest return on investment repairs include things like new siding, energy-efficient windows, and a new garage door.
  • Refinance to a shorter term loan. Shorter term loans allow more of your money to go toward your principal balance instead of interest by making larger payments each month.

Not caring for your property or living in a neighborhood with decreasing property values can lower your home’s equity. Make sure you properly maintain your home and do what you can to keep your neighborhood a good place to live.

What Is a Home Equity Loan and How Does It Work?

A home equity loan is an opportunity to borrow against your home equity. Usually, lenders allow you to borrow up to 80% of your home’s equity. This is also known as an 80% loan-to-value (LTV) ratio. The equity you have serves as the collateral for the loan — meaning if you default, you could lose your home to the bank. Usually, lenders order an appraisal so they can get an idea of the current value of your home before determining your final LTV ratio.

You might also have heard a home equity loan called a second mortgage. That’s because you’re taking out a new loan in addition to your existing mortgage. This loan has a set repayment term and monthly rate that you pay completely independent of your other mortgage debt. Interest rates for home equity loans are usually higher than standard mortgage rates, but they are usually lower than credit cards or personal loans.

To be eligible for a home equity loan, lenders look for a few things:

  • Credit score. Lenders may want you to have a credit score above a certain amount to prove you are financially responsible enough to handle a second loan.
  • Debt-to-income (DTI) ratio. Lenders usually want to see a DTI ratio of less than 43%. You can calculate your DTI by adding up your monthly debts (including credit cards and student loans) and dividing them by your monthly income before taxes.  

With a home equity loan, you receive your cash as a lump sum, and you can use the entirety of it right away. 

Advantages of a Home Equity Loan

Unlike other types of loans, home equity loans have a set interest rate and repayment period. This ensures you know what you pay from month to month, eliminating uncertainty with your budget. These interest rates are also usually cheaper than credit cards or personal loans.

Because home equity loans are technically a second mortgage, they also usually come with longer repayment timelines. Many give you up to 30 years to repay what you’ve borrowed, meaning your monthly payments are usually lower than other types of loans.

Another major benefit of a home equity loan is the ability for tax deductions. If you use the money from your home equity loan to improve your property, the government might allow you to deduct the interest from the loan. For example, if you put on a new addition to your home, the interest on your loan becomes a tax-deductible expense.

Disadvantages of a Home Equity Loan

One of the biggest drawbacks of a home equity loan is the chance of losing your house to the bank if you default. If you’re unable to pay back the loan, the bank is legally allowed to take possession of your home since you used it as collateral.

Home equity loans can also cause trouble if the housing market fluctuates in the wrong direction. If the housing market crashes in your area, it could decrease the value of your home. You might end up owing more on your home than it’s worth, which is also known as being underwater or upside-down on your mortgage.

While closing costs are lower than those of a typical mortgage, you still need to pay them with a home equity loan. They can be around 2% to 5% of your total loan amount. This can add up fast. On a $150,000 loan, that’s up to $7,500 in fees.

Home Equity Loans vs. HELOCs

A home equity line of credit (HELOC) is slightly different than a home equity loan. With this type of loan, rather than receiving a lump sum of cash at once, you have what’s called a draw period. These usually last around 10 years. During this time, you can draw from your equity lines of credit as often as you wish, as long as you do not pull more than 80% of your equity. You make interest-only payments during those 10 years. After the draw period ends, you enter a repayment period where you make variable monthly payments until you pay off the balance.

Banks usually do not let you take out both a HELOC and a home equity loan at the same time, so it’s important to decide upfront which option is ideal for you.

Typically, HELOCs can be a good choice for homeowners who know they need ongoing cash infusions over a larger span of time. For example, if you plan on doing many smaller projects over a couple of years, a HELOC gives you access to cash when you need it. Home equity loans, on the other hand, are better for bigger projects where you need a lot of cash at once, such as adding in a pool or redoing your kitchen.

When Should You Consider Borrowing Against Home Equity?

When borrowing against your home equity, it’s a good idea to use the money to improve your home in some way. Otherwise, you risk having your home value decrease and going underwater on your mortgage.

Borrowing home equity can be an excellent tool for many homeowners in the following instances:

  • You are planning home improvement projects. If you want to do a project that exceeds your credit limit, a home equity loan can give you the funds you need. You can improve the function or style of your home to make it more comfortable to live in, as well as increase its value. Additionally, you may even be able to deduct the interest on your loan.
  • You want to expand your home. Adding on an additional room or wing in your home is a good case for using home equity. You are increasing your home’s square footage, which should raise its value accordingly.
  • You want to pay your student loans. Depending on the financial climate, mortgage rates can sometimes be more affordable than student loan rates. Plus, since mortgages usually have a longer term than student loans, this can reduce the monthly payment size, making it more affordable for recent graduates.
  • You are consolidating debt. If you have a lot of high-interest credit card debt, you can use home equity to pay it off. Make sure you address any spending issues you have so you do not dig yourself into a deeper hole.

When to Not Borrow Against Home Equity

Because you’re putting your home up as collateral with a home equity loan, it’s not a good idea to use the money for things without concrete value. For example, it may not be wise to use your loan to fund vacations or purchase a new car. Going into debt to fund your desired lifestyle can lead to even more debt that’s harder to get out of.

It’s also not advisable to use your home equity for investments, especially in real estate. It’s common for the real estate market to surge up and down depending on economic conditions. If the market drops unexpectedly, you could find yourself underwater on multiple mortgages.

Whenever you’re considering a home equity loan to pay off debt, do a thorough comparison of your current debt payments and estimated new monthly payments. If the new payment is not much smaller, you’re often better off continuing with your current repayment plan.

How to Get a Home Equity Loan

Getting a home equity loan has a few steps. You may need to meet a few requirements before a lender is willing to offer you a loan. Understanding this upfront can help you strengthen your chances of a successful application.

Consult the Requirements For a Home Equity Loan

Every lender has its own requirements when it comes to offering home equity loans. Some of the more common requirements include:

  • Having at least 20% equity in your home. If you have not built up enough equity in your home, a lender is less likely to offer you a loan. Many people put down 20% equity right away with their down payment, but if you did not, you might have to make a few years of payments first.
  • Having a credit score above 620. Your credit score is often used as an indicator of how well you manage your finances. The lower your score, the higher risk a lender considers you. Generally, 620 is as low as most lenders consider, so do what you can to raise your score for more favorable rates.
  • Having a debt-to-income ratio of less than 43%. Your DTI is your total monthly debts divided by your total gross monthly income. That number should be less than 43% to secure a loan.

Get Ready For a Home Appraisal

Before a lender gives you a loan, they need to figure out the current market value of your home. To do this, they will order a home appraisal. During a home appraisal, a licensed appraiser comes to your home to learn about its condition and size. They then use this data and compare it to previously sold homes with similar characteristics to determine an estimated value for your home.

To make sure your appraisal goes well, do a few things to prepare:

  • Make sure every area of your home is accessible, including the basement and closets.
  • Do a thorough cleaning so that your home appears well-maintained and in good shape.
  • If possible, perform any small repairs that could decrease your home’s value, like rotting wood trim or gutters that are falling off your house.
  • Consider your home’s curb appeal and make sure your lawn is in good shape.

All of these things can help the appraiser see your home in the most favorable light and environment possible.

Apply For a Home Equity Loan

The steps to apply for a home equity loan are a lot like taking out your first mortgage. First, gather a number of documents related to your financial and homeownership history:

  • Records of your income for the past two years
  • Copies of your W-2 statements
  • Tax returns from the past few years
  • Appraisal records for your home
  • Your mortgage statement
  • Paperwork for any other debts related to your home
  • Proof of homeowners insurance
  • Last 30 days’ of pay stubs

Your specific lender may have additional documents they need from you, so stay in close contact with them. Each lender likely also has an application you fill out that requests personal details like your Social Security number and address.

Once you’ve submitted everything, you must wait a few weeks or months for the underwriting process to complete, which is where the risk assessment and evaluation takes place. The final step is meeting with your lender and a notary to finalize the loan paperwork and close.

Can You Get a Home Equity Loan With Bad Credit?

You can get a home equity loan with bad credit. As long as you’ve built up a solid amount of home equity and have a low DTI, lenders might overlook a lower credit score. Negative information, like late payments, can affect your credit score for 7 years. Building equity and having a solid income are signs that you’re turning your financial well-being around, even if your score has not caught up yet.

The main caveat with getting a home equity loan with bad credit is that you may pay higher interest rates and fees. A low credit score means the bank is taking a higher risk loaning you money, so they charge more to make up for it.

Other Options to Consider

A home equity loan is not your sole option if you need cash. You might consider cash-out refinancing if you still want to use your home’s equity. Or, if you’d rather leave your home’s equity untapped, a personal loan provides another alternative.

Home Equity Loans vs. Cash-out Refinancing

Cash-out refinancing allows you to pull equity out of your home by refinancing your mortgage. Rather than taking out a loan separate from your mortgage, a cash-out refinance adds your existing mortgage and the equity you’re withdrawing into one new loan. Like with home equity loans, banks prefer you to have a DTI of 43% or lower, a good credit score, and at least 20% equity in your home. Both also limit you to taking out 80% of your home’s total value.

Cash-out refinancing can be a good idea if you are currently stuck with a high mortgage rate. You may be able to refinance your mortgage at a lower rate while also accessing the capital you need. However, if you’re happy with your mortgage rate and would rather keep your loans separate, a home equity loan is a better choice.

Home Equity Loans vs. Personal Loans

With a personal loan, you are not tying your home directly to your loan. Your lender may still use your home as collateral, but you can also offer up other possessions or investments. Since there’s no set amount of equity you need to take out a personal loan, requirements can vary greatly from bank to bank. Still, the process is likely the same. You provide your financial information to the bank, and they review it and let you know how much they can offer you.

Personal loans typically have much higher interest rates than home equity loans, meaning you might pay more overall. However, if you have excellent credit, you might be able to secure low rates regardless. Additionally, since personal loans aren’t tied to your house, you can take them out no matter how much equity you have built up.

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