What is a home equity loan?
A home equity loan is a second mortgage. Just like your first mortgage, a home equity loan is a secured loan. If you don't pay the loan as promised, the lender can repossess your home (the collateral), sell the property, and recoup the loss.
One difference between a home equity loan and other loan types is that if the funds are used to make renovations or additions to your home, you may be able to deduct the interest.
Note: Before applying for a home equity loan, make a plan for what you'll do if you run into a financial problem like an unexpected illness or job loss. Because your home is on the line, it pays to have an emergency fund that ensures payments get made no matter what's going on.
How does a home equity loan work?
When you take out a home equity loan, the funds are dispersed in a lump sum and repaid in monthly installments. A home equity loan can be used for just about anything, including home maintenance and upgrades, travel, a wedding, or debt consolidation. The interest rate and monthly payments are fixed, making it easy to budget with confidence. The APR is typically lower on a home equity loan than on a non-secured personal loan, because your home guarantees the loan and that lowers the risk for the lender.
The loan terms for most home equity loans range from five to 20 years, although they can stretch as long as 30 years. Some home equity lenders charge upfront fees or closing costs, although some lenders will take care of closing costs for you.
How much can I borrow?
The first requirement is that you have enough home equity to borrow. Lenders typically require that borrowers have at least 20% of their home's value in equity. To learn how much equity you have available, the lender orders a home appraisal. The cost of the home appraisal is added to the fees you pay at closing.
Let's say your home appraises for $350,000, and you have a mortgage balance of $200,000. That means you have $150,000 in equity. The next step is to figure out how much of that equity you're eligible to borrow. Lenders typically let you borrow up to about 85% of your home's current market value. That includes your first mortgage if you still have one. Each lender also has a minimum and maximum loan amount.
For example, if your home is worth $500,000, and you still owe $150,000 on your mortgage, you could potentially borrow another $275,000 before your debt is 85% of your home's value.
85% of $500,000 is $425,000
$150,000 on the first mortgage plus $275,000 on a home equity loan equals $425,000
However, if the lender's home equity loan limit is $200,000, then that's all you can borrow even if you have more equity.
Requirements for a home equity loan
To qualify for a home equity loan, you'll need to provide your lender with a collection of documents, including:
- W2 or 1099 income statements for the past two years
- Bank statements for three months
- Federal tax returns for two years
- Recent paycheck stubs
- Proof of other income sources like Social Security payments or tips
- Proof of investment income
A lender will also check your:
Debt-to-income (DTI) ratio
To qualify, your DTI typically cannot be higher than 43%. To calculate your DTI, add up your monthly payments (for fixed expenses, like mortgage, auto loan, child support payments, credit card payments, and other loan payments). Once you come up with that total, divide the number by your monthly gross income (the amount you earn before taxes).
For example, if your monthly bills amount to $3,000 and your monthly gross income is $9,000, your DTI is 33%. (The math looks like this: $3,000 ÷ $9,000 = 0.33).
Credit score
A lender will run a credit check, with most lenders looking for a FICO® Score ranging from 620 to 700. While you may be approved for a loan with a lower credit score, the interest rate is likely to be higher.
What's the difference between a home equity loan and HELOC?
It's easy to confuse a home equity loan with a home equity line of credit (HELOC), but they're not the same. Here's how they differ:
Disbursement
When you get a home equity loan, you get the money all at once. Then you start making equal monthly payments until it's paid off.
When you get a HELOC, you can borrow, repay, and borrow more, up to your credit limit, for the first few years (sort of like a credit card). This is called the draw period and it might last five to 10 years. Once the draw period ends, you begin your repayment period.
Payments
A home equity loan typically comes with a fixed interest rate and a fixed monthly payment.
Most HELOCs have a variable rate, which means the interest rate and the required payment amount can change with the economy. Some HELOCs have a variable rate until your draw period ends, and then a fixed rate once your repayment period starts. Another type of HELOC gives you a new, potentially different, fixed rate each time you withdraw funds. These are sometimes called hybrid HELOCs. It is possible to find a fixed-rate HELOC that gives you a fixed interest rate on day one but they are harder to find.
Some HELOC lenders only require interest payments during the draw period. In this case, your payment amount will spike when your draw period ends. Other lenders require a regular principal plus interest payment on the amount you have withdrawn, even if you are eligible to continue to withdraw more money.
How to find the best home equity loan lenders
Like the best mortgage lenders, the best home equity loan lenders have several things in common, including:
- Low interest rate
- Repayment terms that work with your budget
- Strong customer service
It pays to shop around when you're looking for a home equity loan. Most lenders run a soft credit check before making a loan offer. As opposed to a hard credit check, a soft check does not ding your credit score. It's not until you decide to accept a loan offer that the lender runs a hard credit check. And even if the credit check lowers your score by a few points, the effect is temporary.
Pros and cons of home equity loans
Like most things in life, home equity loans have pluses and minuses. Here, we break down the pros and cons.
