How Does a Home Equity Loan Work?
A home equity loan is a type of loan that allows you to borrow a part of the value of your home above and beyond what you owe on a mortgage. Home equity loans are typically distributed as lump-sums and paid back over several years using fixed monthly payments.
What is home equity?
Home equity is the amount of your home you actually own. You can compute your equity by subtracting your mortgage balance from your home’s current value. If you have any other loans that are secured by the house, subtract those balances from the home’s value too. When you buy a house, your down payment serves as your first chunk of home equity — sometimes as much as 20% of the purchase price. Your equity will increase as you make payments and as the market value of the property increases.
To access the equity you have in your home, you must get a home equity loan or home equity line of credit (HELOC). A home equity loan functions as a second mortgage and means you owe more on the house, resulting in less equity. These loans typically come with 10- or 15-year terms, during which time you must make monthly payments in addition to your mortgage payments.
How does a home equity loan work?
A home equity loan is a secured loan that is collateralized by your home’s value. Because the loan is secured by the property, you could lose your home to foreclosure if you fail to make your payments. Getting a home equity loan requires working with a mortgage lender. It also requires completing a series of steps, including:
- Loan application
- Underwriting
- Appraisal
The home equity loan process is similar to a traditional mortgage process and can take several weeks or longer. Lenders also charge fees when issuing home equity loans, typically amounting to between 3% and 4% of the loan amount.
Home equity loans are repaid via equal monthly payments consisting of both principal and interest. You’ll pay more interest at the beginning of the loan because the principal balance is higher. The loan balance drops as you repay the principal, lowering the amount of interest you pay each month.
Interest rates on home equity loans
Just like a mortgage loan, a home equity loan comes with a stated interest rate. These rates come in two forms: fixed and variable, but fixed is more common. Home equity interest rates tend to be higher than traditional mortgage rates, but they’re lower than rates for other loan types, including personal loans.
Fixed-rate home equity loans
Home equity loans typically come with fixed rates. A fixed interest rate stays the same throughout the life of a loan, resulting in equal payments for the loan’s duration.
Calculating your home equity loan payment
You’ll have to make monthly payments on a home equity loan, just like your first mortgage. Before turning your equity into cash, make sure you can afford the payments using a home equity loan calculator. You can also ask your mortgage lender to assist you.
Home equity loan payment amounts depend on:
- Amount borrowed
- Interest rate
- Loan term
You can lower the payment by looking for the best home equity loans, as the best loans tend to have the lowest interest rates. You can also reduce your payment by choosing a longer loan term, like 15 years instead of 10.
Home equity loans and taxes
If you get a home equity loan, you may be able to deduct the interest you pay to your lender. However, to be eligible to deduct your interest costs, you need to use the funds received from your loan to buy, build, renovate or improve real estate. If you use the money for another purpose — such as paying bills or going on vacation — then you won’t likely be able to deduct any interest.
Type of properties that qualify for home equity loans
Several types of properties qualify for home equity loans, including primary residences, properties you are renting and vacation homes. That said, investment properties pose more risk to lenders so interest rates and terms may be less competitive than for a primary residence.
Applying for a home equity loan
Applying for a home equity loan is similar to applying for other loans, but usually requires more documentation and a property appraisal. You’ll likely need to provide financial documents, such as pay stubs and tax returns. You must agree to a credit check, and many lenders also require income verification.
While your lender is assessing your creditworthiness for a loan, they may also order a home appraisal (if one hasn’t been completed recently). The appraiser’s report includes your home’s current value based on sales of comparable properties and will be sent directly to your lender, which will use it to calculate your equity. Based on this information, the lender will determine how much you can borrow through a home equity loan.
Home equity loan requirements and eligibility criteria
In general, you’ll have the highest approval odds and qualify for the lowest rates for home equity loans if you have excellent credit, high income and low debts. Lenders evaluate loan applications in several ways:
- Calculating your debt-to-income (DTI) ratio
- Evaluating your credit score and overall creditworthiness
- Assessing your overall financial health, including how much equity you have in your home
Your DTI ratio reveals if you have enough income to pay your debts. Lenders typically require borrowers to have a DTI of 43% or less for first mortgages, though some will go up to 50% for home equity loans. Credit score requirements vary by lender, but most require a score of 680 or higher.
When evaluating your home equity loan application and calculating a loan amount, lenders will also evaluate how much equity you have in the home. Most lenders require a loan-to-value (LTV) ratio of at least 80%, meaning you must have at least 20% equity in your home.
Getting a home equity loan for bad credit
Getting a home equity loan with bad credit can be difficult, but it isn’t impossible. First, look for lenders that have lower credit score requirements. If your score is lower than 680, spend some time improving your score. You can also increase your chances of qualifying for a loan by decreasing your DTI to below 43%. Paying down debts will likely improve your credit score, which can further improve your approval odds. Finally, consider using a cosigner with a high credit score. The lender will consider the cosigner’s credit score in addition to yours, which can make it easier to qualify.
Why take out a home equity loan?
There are several reasons you might take out a home equity loan, and you can use the loan proceeds in many ways. For example, you can use a home equity loan to finance home renovations, upgrades or construction of an addition. Many home improvements can increase the value of a home, so this may be money well spent.
You can also take out a home equity loan to pay off high-interest credit card balances or other debts. When consolidating debts through a home equity loan, you can streamline monthly payments and may be able to save money on interest or reduce your monthly payment amount.
How does a home equity line of credit work?
A home equity line of credit (HELOC) is similar to a home equity loan in that they are both secured by your home’s equity. A HELOC is a line of credit you can borrow from when you need cash. When approved, you can borrow up to the approved amount — called a draw — on an as-needed basis. Interest only accrues on your outstanding balance, and you only make monthly payments on the amount you borrow.
Once you repay the full balance, you can borrow from it again and again up to the limit and until the draw period ends. That means you can reuse a HELOC as many times as you want during the draw period as long as you continue making the necessary payments.
Summary of Money’s how does a home equity loan work
A home equity loan can be a good option if you need some cash for home improvements, debt consolidation or other expenses. To qualify, you’ll need an appraisal of the property and sufficient equity in your home. You must also meet the lender’s additional loan approval criteria. Borrowing cash through a home equity loan can be a more affordable way to borrow money than alternative loan types and gives you the freedom to spend the proceeds as you wish.