Buying a home is a significant commitment that can be rewarding in the long run. Every mortgage payment increases your home’s equity and gets you one step closer to becoming debt-free. Your property can also appreciate over time and give you a nice return if you sell your home several years from now.
Some homeowners need extra money for a vacation, home improvements, and other expenses. These homeowners can turn to home equity loans to get the additional financing they need. Home equity loans are exclusive to homeowners and have many benefits over other types of loans.
What Are Home Equity Loans?
Home equity loans are financial products that tap into your home’s equity for capital. These loans typically have fixed interest rates, but you can also opt for variable interest rates with some lenders. Fixed interest rates result in consistent monthly payments, while variable rates result in fluctuating monthly payments. A rising interest rate will increase your monthly payment on a variable-rate loan, while a declining interest rate will help you save money.
How Do Home Equity Loans Work?
Home equity loans give you extra capital, but what else should you know? These loans use your home as collateral. That means if you fall behind on the loan and cannot repay it, the lender can take possession of your house. This is the worst-case scenario for many homeowners, but lenders will work with you to avoid this scenario.
You can extend the loan’s duration to minimize your monthly payments. Lenders also have safeguards in place to increase the likelihood that a borrower will repay the loan. For instance, borrowers who do not have the best finances may not qualify for a home equity loan. The requirements vary for each lender.
Where Can You Get Home Equity Loans?
Homeowners can get home equity loans from several banks, credit unions, and online lenders. It’s a good idea to branch out and compare offers from multiple lenders. This approach can help you save thousands of dollars and access more of your home equity. Sticking with your current lender or working with the first lender you find can increase your overall costs.
How to Choose the Best Home Equity Loan Provider
What should you look for when comparing loan offers from various lenders? These are some of the key details to keep in mind when assessing loan offers.
APR
The annual percentage rate impacts how much interest you pay over the loan’s duration. A higher APR is less attractive and will make it more expensive to borrow money. You should ideally go with the lender that offers the lowest APR, but you should consider other factors before making that decision.
Loan Costs
You will incur various costs the moment you start the loan application process. Origination fees, administrative fees, appraisals, and other costs will all add up. You can put these costs at the back end of your home equity loan. However, you should compare the loan costs for each lender to gauge how much you will have to pay. Looking for online reviews can give you a better idea of the costs.
Loan Amount
Some mortgage lenders are more generous than others. While it’s common for mortgage lenders to let you have an 80% loan-to-value ratio between your mortgage and home equity loan, some lenders set the maximum ratio as high as 95%.
An 80% loan-to-value ratio means that you cannot borrow more than 80% of your home’s equity between the mortgage and home equity loan. If you have a $800,000 home, you cannot borrow more than $800,000 between the remaining mortgage balance and the home equity loan’s balance. That means if you have a $500,000 mortgage balance, you can only borrow $300,000 for the home equity loan. If the lender allows homeowners to have a 95% loan-to-value ratio, it’s possible to take out up to $450,000 in the previous example instead of the $300,000 limit imposed by an 80% loan-to-value ratio.
Repayment Terms
Home equity loans often have fixed monthly payments unless you have a home equity loan with a variable interest rate. Good lenders will let homeowners choose from various repayment terms. These lenders give you the flexibility to make loans short to get out of debt soon or lengthy, so your monthly payments are smaller. Homeowners should consider lenders that give them flexibility and ultimately allow them to pick repayment terms that work for their budgets.
Eligibility Requirements
Lenders often post their requirements online, so you know if you may get a loan before submitting an application. If the eligibility requirements are reasonable, the lender may be the right choice for you. Lenders with easier requirements may have higher interest rates on their loans. Barely hitting the minimum benchmarks will result in less favorable terms, but if you qualify by a wide margin, you can get a low interest rate for your home equity loan.
Access and Availability
Is it easy to get a home equity loan with the lender, or are there many unnecessary roadblocks? Homeowners should assess how easy it is to go through the application process. You may want to shop around and check out other lenders if a mortgage lender doesn’t give you access to enough funds or is not available for homeowners in your area.
Funding Time
It can take 2-8 weeks to get a home equity loan. Some online lenders can give you a loan much faster than traditional banks and credit unions. Homeowners who need the money quickly should consider this factor and look for lenders with quicker turnarounds. If you can wait up to two months to receive a home equity loan, you can expand your search.
The Pros and Cons of Home Equity Loans
Knowing what goes into a home equity loan can help you save money and get the best deal. However, is a home equity loan even right for you in the first place? These are some of the pros and cons to keep in mind.
Pros
Wondering why so many people use home equity loans? These are some of the perks you will receive from these financial products.
- Consistent monthly payments: You can get a fixed interest rate and make consistent monthly payments. Consistency makes your monthly budget more predictable.
- Get extra capital: You can get the funds you need for home improvements, vacations, and other expenses.
- Lower interest rates: Since home equity loans use your property as collateral, they have lower interest rates than personal loans.
- Lengthy repayment terms: You can spread the principal of a home equity loan across 30 years. That length makes it easier to cover monthly payments since those payments get smaller if you spread the load across more months.
- Tax write-offs: If you use the home equity loan for qualifying expenses, you can turn the interest payments into tax deductions.
Cons
Not every financial product is perfect, and home equity loans are no exception to the rule. These are some of the things to keep in mind before taking out a home equity loan.
- An extra debt: Not everyone has enough financial flexibility to make monthly payments on a home equity loan.
- Interest payments: You start paying interest the moment you receive the loan, and a high rate can make it more expensive.
- Loan costs: Origination fees, administrative fees, and various closing costs all add up. It can cost thousands of dollars to receive a loan.
- You can lose your house: This risk is present for any mortgage or home equity financial product. You can adjust the terms and browse through offers to find a loan that fits your budget. Picking up a side hustle and seeking career advancement opportunities can help you cover the monthly loan payments.
- Higher credit score requirement: Home equity loans have higher credit score requirements than HELOCs. If you do not have the best credit score, a home equity loan may not work for you.
Comparing Home Equity Loans
Homeowners have several ways to tap into their home equity. Here’s how home equity loans compare with some of the other home equity financial products.
Home Equity Loans vs. HELOCs
Home equity loans have fixed monthly payments, and interest accrues right away. The quick accrual of interest is a disadvantage of home equity loans. Home equity lines of credit only accrue interest when you borrow against the credit line. You could theoretically take out a home equity line of credit, never borrow against it, and never pay interest. Some people take out HELOCs as reserves in case a financial emergency hits. Applying for a HELOC in advance means you can tap into the funds right away instead of applying for a loan when the expense is urgent.
However, most HELOCs have variable interest rates. Additionally, while a HELOC has generous payment requirements during the draw period, the remaining balance will convert into a loan at the end of the term. HELOCs can result in a debt snowball of interest payments, while home equity loans have fixed, predictable payments.
Home Equity Loans vs. Cash-out Refinancing
Home equity loans and cash-out refinances both let you access more equity in your home. When deciding between these two, you have to consider if you like your current mortgage. If you secured a low interest rate for your current mortgage and like the terms, a home equity loan is better. A home equity loan is a second loan that does not disrupt your current mortgage.
A cash-out refinance allows you to change the interest rate and terms on your current mortgage. If you improve your credit score and debt-to-income ratio since receiving your first mortgage, you might end up with a lower interest rate if you get a cash-out refinance. You can also use a cash-out refinance to reduce your monthly payments by extending the loan’s duration.
Home Equity Loans vs. Shared Home Equity Agreements
Home equity loans give you upfront capital that you have to repay over monthly payments. Shared home equity agreements give you capital in exchange for a percentage of your home’s equity. Shared home equity agreements do not increase your debt burden and are more readily available for people who have bad credit. People who are in more financial distress at the moment may opt for a shared home equity agreement to protect their monthly budgets.
A key difference emerges when you sell your home. If your property has gained significant value since you received capital, a home equity loan is better. This financial product protects your equity share in your home. However, if your property loses value or stays relatively flat, a home equity agreement is the better choice. Homeowners must consider if they can handle additional monthly loan payments and how much they think their homes will appreciate before they sell.
How Much Can You Borrow with a Home Equity Loan?
The amount you can borrow on a home equity loan depends on the lender’s requirements and the remaining balance on your mortgage. Most lenders limit homeowners to a combined loan-to-value ratio of 80% to 85% between their mortgages and home equity financial products. A lower mortgage balance will increase how much you can borrow from a home equity loan.
Are Home Equity Loans Tax Deductible?
The monthly principal payments are not tax-deductible, but the interest payments may be deductible depending on how you use the funds. If you used the capital to cover home improvements, buying a home, or building a home, you can deduct interest payments from your taxes.
Home Equity Loan Requirements
Home equity loans have several requirements. These are some of the details to keep in mind before applying for a home equity loan.
Home Equity
Financial institutions will look at your current mortgage and compare it to their loan-to-value ratio requirements. Having a lower balance on your mortgage can help you access more capital from a home equity loan.
Credit Score
Most lenders will want to see a 680 credit score or higher if you want to apply for a home equity loan. Some lenders may give you a home equity loan if you have a 620 credit score. These financial products have higher credit score requirements than home equity lines of credit.
Improving your credit score before applying for a home equity loan can go a long way. Not only will you have an easier time getting approved, but a higher credit score also entitles you to a lower interest rate and a higher loan amount. Making on-time payments and paying off your debt balances (i.e., credit card debt) are the two best ways to get extra points on your credit score.
Debt-to-Income Ratio
Your debt-to-income ratio measures your monthly debt payments to your monthly income. If you pay $5,000 in debt each month and earn $10,000 per month, you have a 50% debt-to-income ratio. This mark puts you a tad above what most lenders will accept. Having a 43% debt-to-income ratio will help you get approved for most home equity loans.
Some lenders cater to homeowners with 50% debt-to-income ratios. However, if you have that debt-to-income ratio or barely qualify, you can end up with a higher interest rate. Adding more years to the back end of your loan will improve your debt-to-income ratio since a lengthier term gets spread across smaller monthly payments.
Ability to Pay Debt
Lenders only make a profit from their loans if the borrowers can repay the debt. Lenders will meticulously review your finances and payment history to gauge if you can cover the monthly loan payments.
Demonstrating good payment history on your credit report will help you get a more favorable loan. Borrowers can only showcase good payment history through their actions. Paying your credit card on time each month and addressing your other bills will help you build a pristine payment history. Making on-time payments impacts 35% of your FICO score, which can help you qualify for better loans.
Proof of Homeowners Insurance
You will have to provide proof of homeowners insurance before receiving a home equity loan. Make sure you have this document ready to go during the application process.
How to Get a Home Equity Loan
You can get a home equity loan from traditional banks, credit unions, and online lenders. It is a good idea to compare terms and rates from multiple lenders before choosing the right lender for you.
You will have to provide several documents during the application process. You will need your ID and Social Security number. Homeowners must also provide financial documents, such as their bank account statements, tax forms, and pay stubs. The required documents depend on the lender.
Once your application gets approved, you will have to pay closing costs. These costs include origination fees, administrative fees, appraisal costs, and other expenses. You will then have to wait three days for the funds to access the funds from your home equity loan. It takes three days for the funds to become accessible in case the borrower changes their mind. This is a rule across all banks, credit unions, and online lenders.
