If you own a home, you’ve no doubt run across the term “home equity loan” before. It’s a form of financing that allows you to tap into the equity you’ve accumulated in your home. The most simple home equity definition is the difference between the value of your home and what’s left on your mortgage.
Also called a second mortgage, a home equity loan provides you with funds to achieve a variety of financial goals. You can, after all, use the money for just about anything you need. On the other hand, even though you’re tapping into your equity, it is a loan. That means you have to repay it. You’ll also secure your loan with your house. Meaning if you default on your home equity loan, you’re at risk of foreclosure.
These factors may leave you wondering, is a home equity loan a good option for me? Here’s what you need to know.
Home Equity Loans Pros and Cons
To determine if a home equity loan is right for you, you should take some time to weigh out the pros and cons.
- Lower interest rates. The interest rates for home equity loans are more than first mortgages but typically lower than those attached to personal loans and credit cards.
- Fixed rates. With fixed interest rates, your payments are predictable. That can help simplify monthly budgeting.
- Freedom to use the money how you choose. You can use the money for virtually anything, with some of the most common uses being home repairs and debt consolidation.
- Interest may be tax-deductible. If you use the funds for home repairs or upgrades, the interest you pay on your home equity loan may be tax-deductible.
- Two mortgage payments. When you take out a home equity loan, you’re taking out a second mortgage. This means you’re technically making two mortgage payments instead of one.
- Closing costs. Like your first mortgage, your home equity loan will come with closing costs. They typically range from 2% to 5% of the total loan amount. While you can roll them into your loan, you’ll want to keep this in mind when you apply.
- Your home acts as collateral. If you fail to make payments, your bank can seize your home.
- Rates are higher than with a HELOC. A home equity line of credit (HELOC) is another way to take advantage of your home equity. While interest rates are higher for a home equity loan, you don’t have to worry about potentially fluctuating rates (and therefore fluctuating payments).
Home Equity Loan Requirements and the Application Process
The qualifications you need to meet to obtain a home equity loan will vary from one lender to the next. In general, however, you can expect the following requirements:
- A credit score of 620 or higher
- A solid repayment history
- A debt-to-income ratio of 43% or less
- Sufficient income to repay your loan
- Enough equity in your home (at least 15% to 20%)
The Process of Getting a Home Equity Loan
Before you apply, you’ll want to make sure you meet the lender’s minimum qualifications. You’ll also want to take inventory of your finances to know whether or not you’ll be able to afford the additional monthly payment. If you haven’t already, you might want to consider drafting a budget to see where you stand.
Next, determine how much equity you have in your home. Find out the current appraised value of your home and subtract the amount left on your mortgage. That gives you your total equity. Then figure out how much you’re looking to borrow. Keep in mind you probably won’t be able to borrow all the equity you have. In most cases, you’ll have to leave a set percentage behind. Your combined loan-to-value (CLTV) and your credit score will also play a role in how much you’ll be able to borrow.
When you’re ready, it’s time to apply. Your potential lender will need various documents from you, such as:
- Pay stubs
- Employment history
- Evidence of your other existing debts
- Your current mortgage information
During the underwriting process, your lender may request additional documentation. Provide it quickly to ensure the entire process goes as smoothly as possible. You may find it helpful to gather essential documents before filling out the application in order to expedite the process.
Home Equity Loan Alternatives
You may decide that a home equity loan isn’t the right option for you. Fortunately, you have a few alternatives:
Home Equity Line of Credit
A home equity line of credit (HELOC) is another option for tapping into your home equity. Instead of a loan, however, it’s a line of credit. You can use as much or as little as you want during the draw period, and you only need to repay what you use. The rates are typically variable, so your payments may change during your repayment period.
A cash-out refinance replaces your existing mortgage with a new one. The loan, however, is for more than what you currently owe. You get the difference between the loan total and how much you owe on your mortgage in cash. It can be a great option if interest rates have dropped. However, you may end up making payments on your home for longer than you intended.
If you don’t have sufficient equity in your home or don’t qualify for a home equity loan, you could apply for a personal loan. While a personal loan’s rates are higher than those of a home equity loan, you don’t need to provide collateral to secure it.
A unique option to consider is a sale-leaseback. With this solution, you actually sell your house, but you don’t have to move. Instead, you lease it back for a predetermined monthly rent. You no longer have to worry about the major costs of homeownership, and you access the equity in your home without taking out an additional loan. If you choose to do so, you can repurchase your house later on.
Is a Home Equity Loan a Good Option for You?
A home equity loan can be a great solution for accessing the equity in your home. You can use the money for almost anything, the rates are fixed and favorable, and you may be able to deduct your loan interest. If you meet the qualifications, tapping into your home equity could make it easier to achieve your financial goals.
If you’re looking for an alternative that doesn’t involve taking on additional debt, a sale-leaseback may offer a better solution.
If you own a home, you’ve no doubt run across the term “home equity loan” before. It’s a form of financing that allows you to tap into the equity you’ve accumulated in your home. To determine if a home equity loan is right for you, you should take some time to weigh out the pros and cons. If you are still unsure of home equity loan options, after reading this article, consult a financial advisor to discuss your options.