Home equity loans: A complete guide

How does a home equity loan work?

Home equity loans allow homeowners to borrow a lump-sum of cash that they pay back in fixed installments over a predetermined period. They usually are fixed-rate loans, so the interest rate remains the same throughout the term of the loan.

The amount you qualify for may be more money than you need or can afford. Review your household’s budget before agreeing to any terms. This way, you can ensure you can afford your monthly payments.

For example, say you can qualify for a $100,000 home equity loan, but the kitchen renovation you need to finance will cost $40,000. It’s best to limit the loan amount to your needs to avoid the larger payments on a bigger loan.

Another approach to ensure you can pay the loan back is choosing the best loan terms. You can choose anywhere between a 10- to 30-year loan term, depending on your goals for the loan. A 10-year term, while offering a quicker payoff, will have larger payments.

How to get a home equity loan

To get a home equity loan, you’ll need to qualify, which means your lender will calculate your equity and debt-to-income ratio, and pull your credit score. So, if you’re weak in one area, the other two can help boost your qualifications. Here is what each of these steps looks like:

1. Determine your equity with a home appraisal

To decide whether you qualify for a home equity loan and how much money you can borrow, your lender will have your home appraised. The home appraisal will tell the lender how much your home is worth, how much equity you have, and how much you can borrow.

For instance, Rocket Mortgage® will let you borrow up to 90% of your home’s value. 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 90% 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’d calculate the potential home equity loan amount:

$400,000 x 0.9 (90%) = $360,000

$360,000 – $100,000 = $260,000

This means you could borrow up to $260,000 with a home equity loan.

2. Calculate your DTI ratio

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 more debt.

Most lenders require a DTI ratio of 43% or less to qualify for a loan or mortgage. In some cases, a lender will require an even lower DTI ratio, and in others a bank might accept a higher DTI ratio depending on other factors, such as credit history and income stability.

You can figure out your DTI ratio using the following equation:

DTI = Total Monthly Debt Payments ∕ Gross Monthly Income

1.     Add up all your monthly debt payments, including your primary mortgage, student loans, car loan, minimum credit card payment, alimony, and child support.

2.     Divide the sum by your gross monthly income, which is the amount of money you earn each month before taxes and deductions.

3.     Multiply the result by 100 to find the percentage.

For example, if your total monthly debt is $1,500 ($950 for your primary mortgage, $300 for your car loan, and $250 for 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.

3. Check your credit score

Your credit score plays a role in determining whether you qualify for a home equity loan. Individuals with higher credit scores often benefit from lower interest rates.

The minimum credit score needed for a home equity loan is generally around 620, but varies by lender. Some lenders might prefer your score be closer to 680. If you want a home equity loan, a higher credit score may allow you to access more of your equity.

At Rocket Mortgage, a 680 credit score means you can borrow up to 80% of your home equity. If your score is a median of 700 or better, you can access up to 85%. Finally, you can borrow up to 90% of your home’s value if your score is 740 or higher.

Remember that these LTV amounts combine both your primary mortgage and your home equity loan. For example, if you have 45% LTV on your primary mortgage, you can only borrow a further 45% of your home’s value for a total of 90%.

Can you get a home equity loan with bad credit?

Those who have had past credit issues know that it makes borrowing more difficult. It’s also true, however, that people with a lower credit score are more likely to qualify for a home equity loan than a personal loan. Because home equity loans are secured by your home, they’re less risky for lenders because they can foreclose on your loan and take possession of your house if you’re unable to keep up with your monthly payments.

If you’ve built up a fair amount of equity in your home and have a low DTI, your chances of obtaining a home equity loan will be higher despite a low credit score. If you find yourself in this situation, your home equity loan will likely come with a higher interest rate.

Alternatives to home equity loans

Home equity loans are a great tool to help you borrow against your home’s equity. However, you can access the money you’ve built up in your home in other ways. Before you can decide if a home equity loan is the right choice for your needs, you need to understand the alternatives.

Cash-out refinance

A cash-out refinance replaces your primary mortgage with a new loan based on your home’s current value. You keep the difference and repay the loan as part of your new mortgage.

The key difference between a home equity loan and cash-out refinances is your monthly payment. With a cash-out refinance, you receive funds for the equity in your home, just as you would with a home equity loan. However, unlike a home equity loan, you have one monthly mortgage payment instead of two.

If you choose to get a cash-out refinance, you can secure a lower interest rate than with a home equity loan. The discrepancy in interest rates has to do with the order in which lenders are paid when defaults and foreclosures occur.

Home equity line of credit, or 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. However, instead of providing borrowers with a lump-sum payment, HELOCs act more like credit cards. Home equity lines of credit provide you with a predetermined amount of money that you can draw from as necessary. You only pay interest on what you borrowed, not the entire line of credit.

Unlike home equity loans, HELOCs have variable interest rates, which are similar to adjustable-rate loans. This means your interest rate will change 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, but we want to make you aware of your alternatives.

When is a home equity loan the right choice?

Here are a few situations in which a home equity loan makes the most sense:

• You need money fast. A home equity loan is a good choice when you need a large amount of money immediately but want to lock in a lower interest rate than you’d find with a credit card or personal loan.
• You have a fixed budget. Home equity loans can be 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 to choose the best home equity loan

To get the best terms and interest rates, compare loan programs and fee structures from at least a few lenders. Review the Loan Estimate form provided by each lender. Loan Estimates will give you the terms of your home equity loan, including the interest rate, and itemize the closing costs and fees you’ll be charged.

It’s quick and easy to start the approval process on a Home Equity Loan from Rocket Mortgage.

Home equity loan FAQs

Home equity loans make accessing the cash you have tied up in your house easy, but you still need to make sure they’re the right fit for your finances. Here are some other frequently asked questions regarding home equity loans to help you make the right decision.

How does a home equity loan differ from a HELOC?

A home equity loan gives you money in a single lump-sum payment. A HELOC allows you to borrow money as needed up to the limit of the line of credit for a predetermined length of time.

Will taking out a home equity loan hurt my credit score?

Any time you open a new loan, your credit score will drop slightly. The drop will likely be temporary, and your score may even increase after opening the loan since your total available credit will go up.

What should I look for when applying for a home equity loan?

Look for a lender that offers you a home equity loan with a low interest rate, affordable origination fees, fair repayment terms and a monthly payment that fits your budget.

The bottom line: A home equity loan could be right for you

If you’ve built up equity in your home and have a strong credit score and a low DTI ratio, a home equity loan may be beneficial for you. 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. If you’re concerned about your ability to juggle two mortgages, you may want to choose a cash-out refinance instead. This allows you to have one payment at the lowest available interest rate.

Whether a cash-out refinance or home equity loan makes the most sense for you will depend on a blended rate calculation. One of our Home Loan Experts can help you with that. To go over your options, start an application online today.