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Home Equity Loans: How They Work and How to Get One

Mark Henricks
Home Equity Loans
Home Equity Loans

A home equity loan is a type of secured loan. Your home and the equity you’ve built up in it (by making a down payment and mortgage payments) is used as collateral. Borrowing against the equity in your home can be a great way to get a low-cost loan. There are two types of home equity loans: home equity lines of credit (HELOCs) and fixed-rate loans. Each of these have their pros and cons, so be sure to pick the one that’s best aligned with your needs.

What Are Home Equity Loans?

A home equity loan, sometimes referred to as a “second mortgage,” offers a way for homeowners to borrow based on the equity they hold in their home. In other words, you can borrow money based on the difference between the current balance of your mortgage and your home’s current value. The equity you hold in your home represents your collateral.

There are two main types of home equity loans, including:

  • Home equity line of credit (HELOC): A HELOC lets homeowners borrow money as they need. These are usually variable-rate loans, but they carry a specific term length. Once the term is complete, you must repay what you’ve borrowed.

  • Fixed-rate home equity loan: Similar to a standard mortgage, this fixed-rate loan provides you with a single lump sum. As its name implies, you’ll need to make regular payments at a set interest rate for a specific term.

Benefits of Home Equity Loans and HELOCs

Unlike unsecured loans (such as a personal loan) or credit lines (such as a credit card), you’ll use your home as collateral. This is true of both a home equity loan and a HELOC. This means it will be easier to qualify for your loan provided your remaining mortgage value is less than your home’s value.

On top of this, home equity loans have fairly lax requirements. Home equity loans often call for the homeowner to own at least 15% equity in their home. As far as credit scores are concerned, a score of at least 620 is usually enough for approval. Your debt-to-income (DTI) ratio should be no more than 50%.

You’ll also get lower interest rates with a home equity loan than most other similar options. According to ValuePenguin’s 2019 report, the average rate on 15-year fixed-rate home equity loan is 5.76%. For a HELOC, it’s 5.51%. Bear in mind that a HELOC typically carries a variable rate, meaning the interest rate can change as market rates shift.

Beyond this, home equity loans usually let you borrow quite a bit of money. In fact, they can range anywhere from $10,000 up to hundreds of thousands of dollars. You can also use them for just about any purpose. Borrowers may use the money for home renovations, paying off high-interest loans, paying for college and starting a business.

With a home equity loan, the amount of money you can borrow is specific and set in stone. But if you choose a HELOC, you’ll have much more flexibility. This is because you can take out as much as you need, when you need it, up to the limit of the HELOC. Your payments will vary as well.

Home Equity Loan Risks, Limits and Costs

Home Equity Loans
Home Equity Loans

The big risk with a home equity loan or HELOC is that you could lose your home if you don’t pay it back. The point of a secured loan, after all, is that lenders are more willing to lend to you because they know they can take your collateral if you don’t pay. In this case, the collateral is your home. Don’t risk the roof over your head for a low-cost loan if you have any doubt about your ability to pay it back.

The most obvious limitation for a home equity loan is that those who don’t hold much equity in their home won’t be able to get one. You typically need no less than 15% equity in your home to get a home equity loan. For example, if your home’s appraisal is $200,000, you’d have to owe no more than $170,000. Additionally, those with bad credit or substantial debt likely won’t have access to a home equity loan.

Home equity loans and HELOCs also call for stability. If you expect to sell your house soon or have a change in income that would make it hard to pay up, a credit card or unsecured personal loan might be better.

While a HELOC offers nearly instant access to cash, a fixed-rate home equity loan can take a few weeks to dish out your funds. So if you choose the latter, don’t be surprised if you’re forced to wait for the money.

Interest on home equity loans used to be generally tax-deductible. However, the Tax Cuts and Jobs Act of 2017 eliminated this deduction unless the loan is used to buy, build or substantially improve your home. A financial advisor can help you figure out whether your loan is deductible – and, for that matter, whether it’s even a good idea at all.

Bottom Line

If you decide to explore a home equity loan, be sure to shop around. Fees, interest rates and qualifying standards vary widely. Check with banks, credit unions, online brokers and local and national loan originators to get the best deal for you.

Once you’ve chosen a lender, gather your paperwork. You’ll need a home appraisal, tax returns, paycheck stubs and perhaps divorce decrees and other documents. After you’ve submitted your documents and receive approval, you’ll have a closing like the closing for your purchase mortgage. You’ll review and sign a thick pile of documents. At the end, you’ll get a check or have the funds transferred into an account.

Home equity loans and HELOCs have many upsides and downsides. Sometimes a credit card cash advance or unsecured personal loan may be a better choice. You may also explore a cash-out refinance loan. This replaces your first lien mortgage with another first-lien mortgage. It can provide another way to turn your home’s equity into cash.

Tips for Buying a Home

Home Equity Loans
Home Equity Loans
  • The most important step in the home-buying process is figuring out how much home you can afford. Stop by SmartAsset’s home affordability calculator to set your budget.

  • Buying a home and managing your equity in it can be extremely complicated. If you’re looking into a home equity loan and are unsure if it’s the right choice for you, it might be worth consulting with a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.

Photo credit: ©iStock.com/William_Potter, ©iStock.com/sturti, ©iStock.com/PrathanChorruangsak

The post Home Equity Loans: How They Work and How to Get One appeared first on SmartAsset Blog.

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