What Is a Home Equity Loan?
A home equity loan allows you to borrow against your home equity, which is the portion of your home that you own. These loans are sometimes called second mortgages, equity loans, or home equity installment loans. They provide you with a lump sum of money that you can spend however you want. In return, you’ll make monthly payments, typically with fixed interest rates, though some lenders may offer variable interest rates.
Your home serves as collateral to secure a home equity loan. Most lenders allow you to borrow up to 85% of your home’s value, depending on your remaining mortgage balance, home value, income, and credit.
How Do Home Equity Loans Work?
Applying for a home equity loan is similar to applying for a mortgage. Whether you apply online or in person, you should be prepared with the following information and documentation:
- Your Social Security number
- Employment history and employer information
- Proof of income, such as tax returns
- Most recent pay stub
- W-2 statements from the last two years
- Amount you pay in alimony or child support, if any
- Current mortgage statement
- Home appraisal information
- Proof of homeownership
- Home insurance declarations
- Documentation of existing liens on your home, if any
Your combined loan to value ratio (CLTV), credit score, payment history, and income determine how much you can borrow and your available interest rate. Home equity loans typically have a set repayment term and fixed interest rate for the life of the loan, although you may occasionally find a home equity loan with a variable interest rate.
You can expect to pay origination fees and closing costs as with a mortgage. You may also be subject to late fees for delayed monthly payments or prepayment penalties if you pay off the loan before the term is over. Reviewing the loan offer carefully and asking questions can help you plan for the necessary fees.
The entire process can take about two to six weeks from the time that you apply to when you receive funds. You can usually expect online lenders to be faster than traditional banks and credit unions.
The underwriting process takes up the majority of this time as an underwriter compares your borrowing history, creditworthiness, and financial documentation to the requirements of your loan. When underwriting is complete, you’ll close the loan by meeting with your lender to sign paperwork and arrange for funds disbursement. Closing can take about a week.
How to Evaluate Your Home’s Equity
You can figure out your home’s equity by subtracting the amount you owe on your mortgage from your home’s appraised value. That formula looks like this:
Current home appraisal value – mortgage balance = home equity
For example, let’s say you want to get a $50,000 home equity loan and the current market value of your home is $300,000. You have a 30-year mortgage with a remaining balance of $180,000. $300,000 minus $180,000 equals $120,000. You currently have $120,000 in home equity, 40% of your home’s total appraised value.
Lenders also review your loan-to-value (LTV) ratio and CLTV ratio. When you already have an existing mortgage, your LTV compares your mortgage balance to the appraised home value. In our example, your LTV ratio would be 60%. That equation looks like this:
(Mortgage balance / current home appraisal value) x 100 = LTV ratio percentage
Determining your CLTV ratio can help you see if you meet the 85% maximum required by most lenders. To determine CLTV, add the desired loan amount to your current mortgage balance, then divide that number by the current appraised value. Finally, multiply by 100 to turn that number into a percentage:
(Home equity loan + mortgage balance) / home appraisal value x 100= CLTV ratio
In our example, you would add $50,000 to $180,000, then divide that number by $300,000. Multiply by 100 to get a 77% CLTV ratio, which most lenders would approve.
When Should You Get a Home Equity Loan?
Although it’s technically possible to get a home equity loan when you first purchase a home, timing might not be ideal. Most lenders require that you have at least 20% equity in your home before approving you for a home equity loan. The more equity you own and the less you owe on your initial mortgage, the better rates and terms you can get. If you have less equity in your home but need funds now, you will likely pay a higher interest rate for a loan.
Your debt-to-income (DTI) ratio also factors into when you might choose to get a home equity loan. Most lenders require a DTI ratio of no more than 43%. You can determine your DTI ratio by dividing your total monthly debts (mortgage, auto loans, student loans, etc.) by your monthly gross income. You may need to pay off other debts or increase your income before applying for a home equity loan.
You might consider a home equity loan if you need cash but have a low credit score. Since home equity loans are secured, they usually have looser approval requirements than for personal loans and other unsecured loans. You could get a credit card in this situation, but if you plan on carrying a balance, home equity loans have lower interest rates.
Although home equity loans can be spent on anything, some investments are riskier than others. For example, using a home equity loan to purchase an extravagant car might not be worth it, since your home acts as collateral for the loan. Likewise, starting a new business with the funds presents a higher risk, so be sure to weigh the pros and cons.
Home Equity Loan vs. Home Equity Line of Credit
Home equity loans and home equity lines of credit (HELOCs) are similar, but have a few key differences. Both loans use home equity as collateral for the loan. However, home equity loans provide you with a lump sum of cash, repaid over a set term with a set interest rate. You repay the money over the lifetime of the loan. Terms generally range from 5 to 15 years.
With HELOCs, you get access to a revolving line of credit with a variable interest rate, though some lenders do offer fixed-rate options. Like a credit card, you can take what you need up to your credit limit, pay it back, and borrow more. HELOCs have a draw period, which typically lasts 5 to 10 years. The draw period is followed by a repayment period of about 10 to 20 years, during which you must repay your balance and can no longer draw money.
How to Choose the Best Home Equity Lender for You
When getting any type of loan, it’s important to compare different options. Marketplaces like LendingTree make it easy to compare multiple lenders in one place, without having to apply on multiple sites.
You should compare the interest rate, APR, and terms of each lender. Some lenders may offer prequalification offers, waived fees, or other discounts that should be considered as you deliberate.
You should also consider customer service and user interface. You don’t want to be stuck in a long-term loan with a lender that has poor customer service, so read reviews or test out their customer service yourself to ensure you’re in good hands.
A good lender will also have an easy-to-navigate user interface, like a customer dashboard or mobile app that allows you to pay your bills and track your mortgage. This will ensure a hassle-free experience throughout the lifetime of your loan.
Why should I get a home equity loan?
A home equity loan can provide access to a large amount of cash with a potentially low interest rate. You can use the funds for any purpose from education to home improvements to travel.
How hard is it to get a home equity loan?
To get a home equity loan, you’ll need a minimum credit score of 620 for most lenders and at least 20% in home equity. The higher your credit score and equity, the easier it is to get a home equity loan with good rates and terms.
Can I get a home equity loan with poor credit?
Yes. While most home equity loans require a credit score of at least 620, some lenders, like Hometap, accept credit scores as low as 500.
What is a good rate for a home equity loan?
A good rate can fall anywhere between 3% to 5%, and poor credit may result in less desirable rates of 9% to 10%.