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Home Equity Loans: A Complete Guide

Andrew Dehan10-minute read

November 29, 2022

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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.

Read on to learn more about home equity loans and other ways to take advantage of your equity to decide if this loan option is right for you.

 

What Is A Home Equity Loan?

A home equity loan is a type of loan that enables you to use the equity you’ve built in your home 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.

Home equity loans are often called second mortgages because you have another loan payment to make on top of your primary mortgage.

Rocket Mortgage® is now offering the Home Equity Loan, which is available for primary and secondary homes.

Want to use your equity to get cash?

A cash-out refinance is a more affordable option.

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.

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.

Pros

  • They are easier to qualify for than many other types of 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, making them predictable.

Cons

  • 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.

If a home equity loan doesn't seem quite right for you, you may still have other options for leveraging your home equity. For example, a cash-out refinance might be a better choice for you. Try exploring your options to figure out what financing path works best for you and your current mortgage.

How To 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.

Rocket Mortgage will allow you to borrow around 90% 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 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 would calculate the potential loan amount:

$400,000 x .9 = $360,000

$360,000 – $100,000 = $260,000

This means you could secure up to $260,000 if you obtained a home equity loan.

Debt-To-Income Ratio

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 45%. 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 loans, 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.

Credit Score

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 despite a 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?

Home equity loan rates are dependent upon the prime rate, credit score, credit limits, lender and loan-to-value (LTV) ratios.

Home Equity Loans Vs. Other Options

Home equity loans are a great tool to help you borrow against your home’s equity. However, they’re not the only way you can access the money you’ve built up in your home. Before you can decide if a home equity loan is the right choice for your needs, you need to understand your options. Here are a few alternatives you can look into.

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.

Learn more about the differences between home equity loans and cash-out refinances.

Home Equity Lines Of Credit (HELOCs)

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 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.

Interested in learning more about other ways to use your equity like cash-out refinancing? Researching different financing options is a great place to start if you're looking for the best fit for you and your specific situation.

A cash-out refinance may be a better option.

Use your home equity for cash, at a lower interest rate.

When Is A Home Equity Loan The Right Choice?

Home equity loans aren’t perfect but they can be a great choice for some homeowners. Here are a few situations where a home equity loan makes the most sense:

  • You need a lot of 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. Since interest rates are fixed, you’ll know how much you’ll owe each month so you can budget for your monthly expenses with ease.
  • You have a strict, 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

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.

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 home equity line of credit (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, like a home equity loan, your credit score may 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 home equity loan with a low interest rate, affordable origination fees, fair repayment terms and monthly payments that fit your budget.

The Bottom Line: Is A Home Equity Loan Right For You?

If you’ve built up equity in your home and 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.

If you’re concerned about your ability to juggle two mortgages, you may want to choose a cash-out refinance instead. To learn more about cash-out refinances and find out how much money you can obtain from your home equity, apply online today.

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Andrew Dehan

Andrew Dehan is a professional writer who writes about real estate and homeownership. He is also a published poet, musician and nature-lover. He lives in metro Detroit with his wife, daughter and dogs.