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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.
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:
There are also some potential downsides you should keep in mind, including:
Regardless, there are several reasons you could and, in some cases, should use 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.
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:
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:
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.