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Frequently Asked Questions (FAQ)

What is a Home Equity Loan?

A home equity loan is a type of second mortgage and uses your home’s equity as collateral (as opposed to first mortgages, which use the property’s value at the time of sale to set your terms). Unlike first mortgages, which are used strictly for home or property purchases, home equity loans let you use your existing equity for other purposes. When you take out a second mortgage, however, you’re not accessing your home’s full value (it’s current market value), but rather the equity you have accumulated relative to its total value. This is an important distinction, as it affects the amount you can borrow against. Your home equity is defined as the current value of your home minus any outstanding loans you have on it, as well as any liens on the property. In other words, your equity is the portion of your home you own without any strings attached. For example, if the current value of your home is $150,000, that is not necessarily your home equity if you’ve taken out a mortgage. The first calculation to make is to multiply the down payment percentage amount and the value of your home (assuming the mortgage covered the rest). In our example, let’s say you put in a 25% down payment your home, making your initial home equity $37,500.

After a few years of payments (and assuming the value of your home doesn’t change), you manage to add another 10% worth against your mortgage, your new equity is $52,500. However, home values rarely stay static, so assuming your property appreciated in those few years by $50,000, your new home equity would be $102,500 since the appreciation isn’t covered by your mortgage.

If you apply for a home equity loan, you’ll be borrowing not against the full value of your home, but against that $102,500 that accounts for your home equity. It’s also wroth noting that when you borrow a home equity loan, you can choose to get your funds disbursed in one of two ways. The first is to receive a lump sum, where the full amount you borrowed is deposited into your account once it’s approved. The second is what is known as a Home Equity Line of Credit (or HELOC), which opens a line of credit based on your approved amount that you can withdraw from the line of credit at your discretion based on needs. It’s worth noting that each of these options comes with slightly different terms. Home equity loans are usually set with fixed interest rates, while HELOCs give you adjustable rates. The benefit of the former is that you immediately have access to your full amount in case you need it for a specific purpose. In the case of a HELOC, you have greater flexibility to use only as much as you need at a given point in time. Additionally, home equity loans and HELOCs both have a shorter repayment term.

Why Should You Consider Taking a Home Equity Loan?

While the idea of a home equity loan is great in theory, it’s not always right for you. Even so, leveraging your home equity is a great way to finance other home projects as well as important events and other needs. There are definite benefits to getting a home equity loan, including:

  • They tend to offer lower interest rates than other loan options. Because home equity loans are made with your home as collateral, you’ll usually find more favorable rates than if you took an unsecured loan elsewhere.
  • Sometimes, you can get tax benefits from a home equity loan. This isn’t always the case, but when you use the loan for home improvements, you can then deduct the interest when itemizing your taxes.
  • They let you take out larger sums. Different from other loans, home equity loans are based on your home’s value, and that is usually a fairly large sum. Therefore, you’ll be able to get more financing for necessary reasons when compared with other loan types.
  • Unlike a first mortgage, your home equity loan is not locked into a specific purpose. Instead, you can choose what to do with the funds once they’re disbursed into your account, with few if any restrictions.

There are also some potential downsides you should keep in mind, including:

  • By using your home as collateral, you risk losing it if you default on the loan. While this is obviously a worst-case scenario, you could have your home repossessed if you fail to pay off your home equity loan.
  • Depending on how the real estate market moves, you could end up “underwater”—owing more than the total value of your home. This would place you in a much tighter financial hole, as you’d still be responsible for paying the loan, but at a much greater risk to your financial health.
  • You will end up with another significant chunk of debt. Depending on how much remains outstanding on your first mortgage, and the amount you’re approved for, you’re going to be re-entering debt in a big way, so it’s best to be prepared.

Regardless, there are several reasons you could and, in some cases, should use a home equity loan:

  1. Upgrading your home – A home equity loan can be reinvested into your home to fund remodeling, repairs, or simply expand it. With some repairs and upgrades, you can even add some value to your home and improve its resale value, though it’s worth noting that not every fix will achieve this. Additionally, you can deduct the interest in some cases when you use your home equity for repairs.
  2. Consolidate other debts – You can use a home equity loan to unify all your existing loans (including those with higher interest rates) or to pay them off. This is a good idea, but it’s one that comes with a caveat. Once you’ve paid off your debt, you should have a plan to keep it off, or risk doubling up your debt due to your home equity loan.
  3. Pay for an education – If you or your children are about to go to college, you can help lighten their financial stress and need for student loans by using your home equity to pay for their degree. This can pay off in the future by putting you and your family in a higher income bracket, but it shouldn’t be your first option, as it comes with higher risks than student loans, for instance.

What Are the Requirements for A Home Equity Loan?

Before the financial crisis hit the US in 2007, it was pretty easy to get approved for a home equity loan, assuming you had a high enough value when you went to the lender. Since then, however, standards have gotten much stricter and now there are more stringent requirements to meet to receive approval. Lenders are more wary of being burned with a default on a massive loan, which is a good thing for both them and borrowers. One of the biggest changes made is that no matter what your home equity is, you’ll not be able to take out a loan for the full amount. Instead, you’ll be generally be limited to roughly 80% of your home’s value. There are also some more requirements that will inform whether you or not you receive approval. The first is the ability to prove you’ll be able to pay back the home equity loan you take out. If your plan is to sell your home immediately after you’ve made repairs or additions, you may think this will satisfy lenders, but you’ll be sorely disappointed. Lenders want to know that you have a tangible, immediate way to start repaying your loan, and will instead require you can prove a steady and sufficient income source.

Additionally, you’ll also need to show that you have an acceptable debt-to-income ratio (how much you owe versus how much you make). For most lenders, this requirement is a debt-to-income ratio of 43% or lower, meaning that your debt payment (along with all your other outstanding loan repayments) can’t exceed 43% of your take-home, pre-tax pay. Next, you’ll have to submit an appraisal of your home to determine its actual value. While you may have an idea about how much your home is worth and what your home equity is, this appraisal will define how much you can get approved for, and if you qualify for a home equity loan at all (if your equity is too low, lenders may reject you). Most lenders want to see that your home equity is at least 15% to 20% of your home’s value. Additionally, lenders may look at your outstanding debt overall. Even with a good credit score and salary, if your existing credit is too high, you may not get approved, or may be saddled with less than favorable rates. Finally, lenders also look at your credit score, though it is weighed differently for a home equity loan than it is for a mortgage. Even so, you’ll still need a generally good-to-excellent score to be approved—lenders usually look for scores starting at 670, though some might accept scores as low as 620. You may still have luck finding a home equity loan with poor credit, but you’ll need to show significant home equity, as well as a low debt-to-equity ratio that will assuage lenders’ questions about your ability to repay the loan.  You should also be ready show a history of paying bills and other debt obligations on time for an extended period.

Home Equity Loans Vs. The Alternatives

If you’re looking to tap into your home’s equity, a home equity loan is just one of the ways to do so. As we’ve mentioned before, while these loans are useful, they come with some drawbacks and requirements that could put them out of reach or make them less valuable than other options. Additionally, you may not qualify for a home equity loan if your debt-to-income ratio is too high, or if you have poor credit. This may seem like the end of the line, but it doesn’t need to be. If you’re still looking for a way to gain additional cash flow through financing or credit, you can explore the following alternatives:

  • Home Equity Line of Credit (HELOC) – We talked about them briefly, but a HELOC is a great alternative to a lump sum home equity loan if you’re looking for credit. While it still taps your home equity and is secured by your home itself, a HELOC lets you control the faucet, taking only as much as you need from the credit pool you’ve been approved for. This makes it easier to control your spending and get more value out of your loan. Additionally, because you’re not receiving the full amount at once, you may be able to lower your overall debt load and payments if you end up not requiring the full amount you were approved for.
  • Personal loans – If you’re looking for a smaller loan for any reason, you may have better luck with an unsecured personal loan. While these start with higher interest rates than home equity loans, they also feature much shorter terms and are extended for smaller amounts. More importantly, because they’re not secured by your home, you don’t run the risk of foreclosure should you default. However, keep in mind that interest rates can be as high as two to three times more than home equity loan rates. Moreover, the amount you can borrow is based on your income and credit scores.
  • Cash-out refinancing – You can also use your home equity by refinancing your existing loan with a cash-out refinance. In this situation, you’re getting a new mortgage that covers the remaining balance on your old one for better rates and terms in addition to extended credit. Cash-out refinancing adds new funds to your existing loan, but it comes with high closing costs. Moreover, you’ll be extending the amount you owe on your original mortgage.
  • Credit Cards – If you’re looking for a line of credit instead of a lump sum, a credit card may still be a better option than applying for a HELOC. While you may end up with revolving credit, you’ll likely be paying less each month and you can use your card for expenses both large and small. Additionally, you’ll be able to build stronger credit through steady repayments. The one downside is that while they offer revolving credit, many have monthly limits which restrict how much you can spend at once, unlike a HELOC.

How to Choose the Best Company for Your Home Equity Loan

Once you’ve decided that a home equity loan is the best option for you, there’s still the matter of finding the right lender to meet your needs. You may be tempted into simply getting a loan with the same provider who extended your mortgage, but you should look deeper into the market before deciding. With the digital boom comes a whole new ecosystem of online lenders, traditional banks, and other providers who can help you get value out of your home equity. Here are some factors you should consider before deciding on the best home equity loans for you:

  • What are the loan limits?
    Before you apply for a loan, you should know how much you want to borrow. Remember that while you may have a significant home equity, you may not need to get a loan for all of it. Moreover, many banks have minimum amounts you must borrow if approved, so if your planned loan is under that, you may be best served going elsewhere. Similarly, many will have a loan-to-value amount cap, usually set at 80%. If either of those don’t match your criteria, you should look elsewhere.

  • Are you eligible?
    This is another important consideration, because if you don’t qualify for a lender, it doesn’t matter if you love their terms. Before you compare lenders, you should start by writing down your financial standing—your credit score, debt-to-income, existing home equity, and more. This will make it easier to see which lenders are more likely to approve you, as well as what you need to improve to qualify. Avoid simply applying to as many lenders as possible, as it may affect your credit.

  • What terms do they offer?
    Home equity loans are usually repaid over a shorter period than mortgages (5 to 10 years versus 15 to 30), but there is still some variability in which terms work best for you. Additionally, you should focus on the interest rate options available. While you won’t be able to choose your interest rate, you still have some control. While most home equity loans have fixed interest rates, some lenders may offer variable, or adjustable, rates. If that’s the case, you should consider how long you want to be paying your loan. If you’re okay with a longer repayment period, a fixed interest rate is best, as it’ll keep your overall payment low. If you’re planning on repaying your loan quickly, a variable rate may help lower your overall payments without the volatility you may experience over a longer repayment term.

  • What fees are included in your price?
    Most home equity loans include a variety of fees that add to the total you pay for your loan. However, not all lenders have the same fees, so you may be paying more for the same amount depending on which lender you choose. Even so, low fees aren’t a guarantee you’ll pay less. Explore lenders’ fees as compared to their interest rates to get a better idea. For example, a company with low fees but high rates may result in you paying more, while high fees and low rates may save you more money over the lifetime of your loan.

  • What is their customer service like?
    Much like with mortgages, you’ll likely be working alongside your home equity lender for a longer period of time, so it’s important that they can meet your needs or solve any problems quickly and effectively. Dig into companies’ customer support staffs and availability to find a lender that can offer the level of service you desire. You may be alright with a company that only offers phone support on weekdays, or instead require 24/7 service that’s only available through live chat. In addition, explore the web to see what other users and experts are saying about each lender. Reading reviews can give you a better idea of major issues or benefits a company may provide that you may not notice after reading their websites.

Introduction to Home Equity

When dealing with mortgages, one of the most important factors lenders will consider is your home equity. In simplest terms, your home’s equity is your property’s current market value minus any liens and outstanding loan balances attached to it. The value isn’t fixed and will change as you pay down your loan (the equity will increase) or get a second mortgage (the equity will decrease). It may also change if the overall value of your home increases due to neighborhood improvements, remodeling, and other factors.

When you take a mortgage to purchase your home, your lender has an interest in your property—they technically own it, although you can still possess it. Your home equity is the portion of your property that you fully own and possess. You can gain initial home equity in your property through a down payment (the larger your initial deposit, the more you’ll have in equity), or over the long term by steadily repaying your mortgage down. Your equity may also passively increase via property appreciation.

You can also use your home equity in some cases to get credit, such as using a home equity line of credit (HELOC). When you take out a second mortgage on your home, lenders will look at your current equity in determining the amount you can borrow. You can either request it in a lump sum, or as a HELOC, which gives you a credit pool to draw from periodically as required.

For example, let’s imagine that the value of your home is $100,000. If you initially paid a down payment of 25%, your home equity is $25,000 initially. Assuming your home’s value remains constant over the next five years, paying down another $10,000 of your mortgage principal with repayments would put your home equity at $35,000. If your home’s value did increase by $100,000, your home equity would suddenly jump up to $135,000, as the appreciation is not covered by the mortgage.

In addition to a second mortgage, you can also use your home’s equity to help in a few different ways. In some cases, you can apply that equity to purchase your new home, using the proceeds from the sale of your previous home to lower your mortgage. Additionally, you can use that equity to get a reverse mortgage, which lets you use it to get a loan that’s fully repaid by the time you retire, and is available to you immediately.