Home Equity Loans: A Complete Guide
Victoria Araj10-minute read
December 21, 2020
Home equity loans are a useful way to tap into the equity of your home to obtain funds when your assets are tied up in your property. They’re generally offered at lower interest rates than other forms of consumer loans because they are secured by your home, just like your primary mortgage is.
Read on for more about home equity loans, as well as other ways to take advantage of your equity, to see if they’re right for you.
What Is A Home Equity Loan?
A home equity loan is a type of loan often referred to as a second mortgage. It enables you to use the equity you’ve built up as collateral to borrow money. Like a primary loan used to buy a house, your home is used as security to protect lenders if you end up defaulting on your loan.
Rocket Mortgage® does not currently offer home equity loans.
How Does A Home Equity Loan Work?
Home equity loans provide borrowers with a large, lump-sum payment that they pay back in fixed installments over a predetermined period. They are fixed-rate loans, so the interest rate remains the same throughout the term of the loan.
Getting Your Money From A Home Equity Loan
Since home equity loans are lump-sum payments, your lender pays you your entire loan amount after the loan closes. Before you get your money, you should determine your budget. The amount of money you qualify for may be more than you need. Know how much you can repay on a monthly basis.
Repaying A Home Equity Loan
After you receive your loan amount, get ready to start paying it back. Your monthly payments will be a consistent amount throughout the term of your loan and include both principal and interest.
You may think it’s best to choose a shorter loan term, so you can pay off your debt faster. Remember, a 10-year term will have higher monthly payments than a 15- or 30-year term.
What Are The Pros And Cons Of Home Equity Loans?
Before you decide to get a home equity loan, you should be aware of the pros and cons. Consider your financial circumstances to determine whether the advantages outweigh the disadvantages.
- They are easier to qualify for than many other consumer loans.
- Interest rates are fixed and lower than many other consumer loans.
- Terms are longer than many other consumer loans.
- There are no restrictions on how you can use the funds.
- You can access the funds immediately in a lump sum.
- Monthly payments are fixed and thus predictable.
- You’ll have a second mortgage to pay off on top of your primary mortgage.
- You risk foreclosure should you default on the loan.
- If you sell your home, you’ll have to pay off the entire balance of the loan – as well as the remaining balance of your primary mortgage – as soon as you close.
- You’ll have to pay closing costs, unlike other consumer loans.
How Do You Get A Home Equity Loan?
To get a home equity loan, you’ll need to qualify, which means your lender will examine your equity, credit score and debt-to-income ratio. These three elements are all taken into consideration so if you’re weak in one area, the other two can help boost your qualifications.
Equity And Home Appraisals
To determine whether you qualify and how much money you can borrow, a lender will have your home appraised. The home appraisal will tell the lender how much your home is worth.
In most cases, a lender will allow you to borrow around 80% of the equity in your home. To figure out the amount you could obtain through a home equity loan, you’d determine your loan-to-value ratio. To do this, subtract the remaining balance of your primary mortgage from 80% of the appraised value of your home.
For example, if your home is appraised at $400,000 and the remaining balance of your mortgage is $100,000, here’s how you would calculate the potential loan amount:
$400,000 x .8 = $320,000
$320,000 – $100,000 = $220,000
This means you could secure $220,000 if you obtained a home equity loan.
When deciding whether to provide you with the loan, your lender will calculate your debt-to-income ratio, which shows how your monthly debt payments compare to your monthly income. This calculation helps lenders determine whether you can afford to take on more debt.
To qualify for a home equity loan, your DTI cannot be higher than 43%. To see if you make the cut, you can figure out your DTI yourself, using the following equation:
DTI = Total Monthly Debt Payments / Gross Monthly Income
- Add up all your monthly debt payments, including your primary mortgage, student loan, car loan, credit card, alimony, child support, etc.
- Divide the sum by your gross monthly income, which is the amount of money you earn each month before taxes and deductions.
- Multiply the result by 100 to find the percentage.
For example, if your total monthly debt is $1,500 (let’s say $950 for your primary mortgage + $300 for your car loan + $250 for your credit card debt), and you earn $5,000 a month before taxes, your DTI would be 30%. In this scenario, your DTI would be low enough to qualify for a home equity loan.
The strength of your credit score also plays a role in determining whether you qualify for a home equity loan. Your credit score is important because it furnishes lenders with a window into your credit history. Individuals with higher credit scores often benefit from lower interest rates.
If you want to obtain a home equity loan, your credit score should be 620 or higher. However, there can be exceptions to this rule.
Home Equity Loans With Bad Credit
Those who have had past credit issues know that it tends to be easier and less costly to obtain a home equity loan than a personal loan. The reason for this is there is less risk involved for lenders because home equity loans are secured by your home. On the other hand, If you’re unable to keep up with your monthly payments, the lender can foreclose on your home to recoup costs.
If you’ve built up a fair amount of equity in your home and have a low debt-to-income ratio, your chances of obtaining a home equity loan will be higher in spite of your low credit score. If you find yourself in this situation, your home equity loan will likely come with higher interest rates and fees.
If your finances demonstrate to lenders you may be unable to repay the money borrowed, you’ll find it more challenging to obtain a home equity loan. Since the housing crisis, more restrictions have been placed on lending practices.
What Are The Home Equity Loan Rates?
The current average for a home equity loan interest rate is 5.76%. The average for a home equity line of credit (HELOC) is 5.51%. Home equity loan rates are dependent upon the prime rate, credit score, credit limits, lender and loan-to-value (LTV) ratios.
How Do Home Equity Loans Compare To Other Options?
Home Equity Loan Vs. Cash-Out Refinance
Home equity loans aren’t the only way you can borrow against your home equity. You can also choose to get the money you need through a cash-out refinance.
While home equity loans enable you to take out a second mortgage on your property, cash-out refinances replace your primary mortgage. Instead of obtaining a separate loan, the remaining balance of your primary mortgage is paid off and rolled into a new mortgage that has a new term and interest rate.
With a cash-out refinance, you receive funds for the equity in your home, just as you would with a home equity loan. Unlike a home equity loan, you only have one monthly mortgage payment.
If you choose to get a cash-out refinance, you usually can secure a lower interest rate than with a home equity loan. The reason for the discrepancy in interest rates has to do with the order in which lenders are paid in the case of defaults and foreclosures.
Home equity loan rates are generally higher because second mortgages are only paid back after primary mortgages have been. As a second mortgage lender, there’s a higher risk that the sale price will be too low for the lender to recoup their costs.
Since you’re able to lock in a new interest rate when you get a cash-out refinance, they are a beneficial option for those who purchased their home when interest rates were high. With a cash-out refinance, you can get cash upfront while also lowering your monthly mortgage payment if rates have dropped since you bought your home. It’s possible they have, given today’s historically low mortgage rates.
Learn more about the differences between home equity loans and cash-out refinances.
Home Equity Loan Vs. Home Equity Line Of Credit (HELOC)
A home equity line of credit is another option for converting your home equity into cash. Like home equity loans, HELOCs are second mortgages. But, instead of providing borrowers with a lump-sum payment, HELOCs pay out more like credit cards. Home equity lines of credit provide you with a predetermined amount of money that you can draw from when necessary.
Unlike home equity loans, HELOCs have variable interest rates, which are similar to adjustable rate loans. This means your interest rate increases or decreases over the loan term as the market fluctuates, as does your monthly payment, making it difficult to anticipate how much you’ll owe. Rocket Mortgage® currently does not offer HELOCs.
A home equity line of credit is a good choice if you need more flexibility. You can take out up to your max any time during your draw period. If you want to be able to draw funds as work is needed over a longer period of time, a HELOC may be right for you.
When Is A Home Equity Loan The Right Choice?
You Need A Lot Of Money, Fast
A home equity loan is a good choice when you need a large amount of money immediately and don’t want to overspend. Since interest rates are fixed, you’ll know how much you’ll owe each month. Having this knowledge will enable you to plan a budget for your monthly payments.
You Have A Strict, Fixed Budget
Home equity loans are the right option when you have one specific expense and are aware of the full amount that you’ll need to spend on it.
You’re Paying Off Higher-Interest Debt
They’re also the better choice if you want to use the funds to pay off other debts that have higher interest rates, as you’ll know your rate won’t change.
How Do You Choose The Best Home Equity Loan?
Choosing the best home equity loan will require you to do a bit of research. In order to get the best terms and interest rates, be sure to compare different lenders’ loan programs and fee structures.
Lenders can have different requirements for qualification and offer different terms for home equity loans. If you have a higher DTI or lower credit score, you’ll find that some lenders are more likely than others to offer you a loan. To ensure that you score the best deal, you’ll want to shop around to find out what your options are.
When determining which lender to choose, make sure you review the Loan Estimate forms provided by each lender. The Consumer Financial Protection Bureau requires all lenders to provide you with this standard three-page form to ensure that you understand the differences between what lenders are willing to offer you. Loan Estimates will give you a rundown of the terms of your home equity loan, including the interest rate, and itemize the closing costs and fees you’ll be charged.
An Option For Those In Good Financial Standing
If you’ve built up equity in your home, have a strong credit score and a low debt-to-income ratio, a home equity loan may be beneficial for you. It will enable you to take out a large, lump sum that you can pay off over an extended period.
Since home equity loans come with fixed interest rates, your monthly payments will never change, and you’ll know exactly how much you need to budget to repay the loan.
Avoid Two Mortgages With A Cash-Out Refinance
With home equity loans, there’s more predictability than with home equity lines of credit. You’ll still be taking out a second mortgage, which means you’ll have two hefty payments to make each month.
If you’re concerned about your ability to juggle two mortgages, you may want to choose a cash-out refinance instead. A cash-out refinance will pay off your primary mortgage and allow you to borrow against your existing equity. This loan option is particularly compelling if interest rates are currently lower than when you purchased your home, as it will replace your existing mortgage with a new loan that has a different interest rate and terms.
To learn more about cash-out refinances and find out how much money you can obtain from your home equity, create a Rocket Mortgage® account.
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