One of the greatest things about owning a home is that you build equity over time. With every mortgage payment, your equity increases.
A home equity loan provides you with access to the money you’ve accumulated in your property. Many homeowners use this type of loan to fund home improvement projects, consolidate high-interest debt, pay for college, or cover the cost of an emergency expense.
How a Home Equity Loan Works
As you repay your mortgage, you accumulate equity in your home. “Equity” is the difference between the value of your home and the amount you still have left to repay. It may grow faster if home values in your area increase.
A home equity loan provides you with a lump sum of cash based on the equity you have in your home. It’s a second mortgage on your house that you have to repay monthly. Your loan has a fixed interest rate, which is based on such factors as your credit score, how much you want to borrow, and your combined loan-to-value ratio. There are always options to eventually refinance a second mortgage as well.
How Much Cash Can You Get?
The important thing to remember with a home equity loan is that you can’t borrow the full amount of your home’s equity. Most lenders only allow you to borrow a maximum of 80% to 85%. So, just how much can you borrow?
There’s a simple formula that you can use to determine how much home equity you can borrow. First, you need to know the value of your home. Multiply that amount by the percentage a lender allows to get the maximum you could borrow. Next, subtract how much you currently owe on your home from the maximum allowable amount to get how much you may be eligible to receive.
Let’s say that your home is worth $275,000, and a lender allows you to borrow up to 80% of your equity. $275,000 x 0.80 is $220,000. Now, let’s say that you still owe $150,000 on your mortgage. $220,000 – $150,000 leaves you with $70,000 that you could get with a home equity loan.
Home Equity Loan Requirements
Now you’re probably wondering how to get equity out of your home. It’s not enough to have it built up. You need to meet a lender’s requirements in order to access it. While the exact requirements vary from one lender to another, here are a few of the general minimums that you’ll need to meet:
- A credit score of at least 620 (although a higher score can help you to get a better rate)
- A debt-to-income ratio of less than 43%
- At least 15% to 20% equity built up in your home
You’ll also need to have your home appraised. You probably remember how much you paid for your house when you first bought it, but home values fluctuate. An appraisal lets you know what you’re home is worth now, so the lender (and you) can determine how much you’re able to borrow.
Pros and Cons of a Home Equity Loan
Before applying for a home equity loan, it’s important to be aware of its benefits and drawbacks. By understanding the pros and cons, and weighing them against the pros and cons of your other options, you’ll be able to figure out if a home equity loan is the best course of action.
- Interest rates are generally favorable, and they’re fixed
- You have access to more money than you would through a credit card or personal loan
- You can use the funds for a variety of purposes, such as home improvements or debt consolidation
- Using the loan for home improvements means you may be able to deduct the interest from your taxes
- If you have a favorable interest rate on your current mortgage, you don’t have to worry about losing it
- A home equity loan uses your house as collateral, which means you could lose it if you default on your payments
- You pay interest on the entire amount you borrow, even if you don’t use it all at once
- As a second mortgage, you do have to pay closing costs (which generally run 2% to 5% of the total amount borrowed)
- If your home’s value decreases, you may end up owing more than your home is worth
- If you sell your home before you repay the loan, you have to pay the balance in full
Home Equity Loan Alternatives
If you’re looking to access the equity in your home, a home equity loan isn’t your only option. Here are a few others to consider:
Home Equity Line of Credit
A HELOC provides you with access to a pool of funds that you can draw on at any time (much like a credit card). You have a set draw period, then a payment period. You only pay interest on what you borrow, although interest rates tend to be variable. During the draw period, you do need to pay a minimum balance (it’s typically interest-only). Your payments may increase during your repayment period.
A cash-out refinance replaces your existing mortgage with a brand-new one. You can refinance your house for what it’s worth now and receive the difference between the new balance and what you owe on your existing mortgage in cash. You can use the funds however you choose. The drawback, however, is that your payments may increase, and it may take you longer to pay off your home.
Another option that many people don’t know about is a sale-leaseback. With this option, you sell your house to someone else and convert your equity to cash. One of the benefits of a sale-leaseback is that you don’t need to move. Instead, you get to remain as a renter and pay monthly rent as outlined in your lease agreement.
A home equity loan provides you with access to the equity you’ve built up in your home to use in almost any manner you see fit. The loan comes with a fixed interest rate that’s typically lower than the rates attached to personal loans and credit cards. The downside, however, is that your home acts as collateral, which means you could lose it if you default.
When deciding if a home equity loan is the best solution, you should speak to a financial advisor to help you compare it closely with other options, such as a HELOC or sale-leaseback. Understanding all of your options will put you in a better position to decide which one is right for you.
You can also explore options for getting home improvement loans with bad credit scores or loans that don’t require any credit score. If you’re looking to qualify for a loan or a loan alternative, talk to a financial advisor today to make sure you’re making the right choice for your needs.