A home equity loan allows you to access cash using the equity in your home as collateral.
You’re not required to spend the money on improving or repairing your home; you can use it for anything like paying off high-interest debt.
This article will take an in-depth look at home equity loan requirements, guidelines, and program eligibility.
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What is a Home Equity Loan?
A home equity loan also referred to as a second mortgage, is a loan that is secured by the homeowner’s equity. Home equity loans are a second loan with a separate payment and term, generally between 5-15 years. The interest rate is lower than other types of personal loans, with an average of around 5%.
Home Equity Loan Requirements
- 680 minimum credit score
- No late payments in the last 12 months
- Loan-to-value ratio must be 70% or lower
- Maximum 45% debt-to-income ratio
- Borrow up to 80% of the home’s market value
Home Equity Loan Pros and Cons
Home Equity Loan Benefits
- Large loan amounts: Personal loans are limited to $40,000; however, with a home equity loan, you can borrower much more if you have a lot of equity.
- Easier Approval: Because you’re using your home as collateral, home equity loans are usually easier to qualify for than other types of unsecured loans.
- Tax deduction: Because the interest you pay on a mortgage is tax-deductible, you may write off the interest you pay on your taxes. Speak to a tax advisor to see if you qualify.
- Increase home value: The best way to use a home equity loan is to make repairs or home renovations that increase your home’s market value.
- Low-interest rate: On average, the rates given to a borrower for a home equity loan are approximately 5%, lower than you will find for a personal loan or other types of loans. Rates will vary depending on the lender.
Home Equity Loan Disadvantages
There are a lot of risks associated with home equity loans, as well. These loans aren’t really intended to fund large unnecessary expenses like going on a vacation or buying a new car. Even paying off credit card debt is not always a good idea, either.
- Lose equity in your home: When you get a home equity loan, you’re going to be losing the equity you have built up in your home over the years, which is why it’s important to spend the money wisely.
- Higher monthly payment: A home equity loan is a loan that you need to pay back monthly, although it is separate from your mortgage payment. Make sure you can afford the monthly payments before closing.
- Secured debt: Remember, home equity loans are secured by your home if, for any reason, you cannot make the payments, you could face foreclosure.
- Loan fees: There are closing costs and lender fees charged whenever you get a home equity loan or HELOC. These fees can be as high as they are when purchasing a new home, between 2-5%.
Home Equity Loans vs. HELOC vs. Cash-Out Refinance
Lump sum payment
Home Equity Loan
Fixed or adjustable rates
Lump sum payment
Line of credit
Home Equity Line of Credit (HELOC)
A home equity line of credit, referred to as a HELOC, is another form of a home equity loan. You will use the equity in your home to get a line of credit, instead of receiving a lump sum. A HELOC works like a credit card; lenders will extend a credit line to you that you can borrow from whenever you need it. You will have minimum monthly payments based on the amount you’ve taken out.
Once you repay it, you can continue to borrow from the credit line. With a HELOC, you’re only charged interest on the amount you borrow.
A cash-out refinance is different in that instead of having a second mortgage, your existing loan is refinanced, and you can borrow additional funds up to 80% of the home’s value. You will have one single loan with one monthly payment that covers your mortgage and the additional funds. Cash-out refinancing is usually easier to qualify for than a home equity loan because the lender is the primary lien holder on your home.
Like other loans, cash-out refinancing will have closing costs and other lender fees to be paid at closing; however, these fees will usually be rolled into the loan.
Frequently Asked Questions
Why do homeowners use home equity loans instead of other types of loans?
Homeowners can usually get a larger loan with a home equity loan because they can cash out up to 80% of the property’s value. Because the home secures them, they can be easier to qualify for than a personal loan. Home equity loans also have lower interest rates than other types of loans.
What advantages are there of home equity loans?
The money can be used to make home improvements or repairs that will increase your home’s value. You can also use the funds to pay off high-interest debt and get a new low rate to repay the debt much cheaper.
If you pay off your credit card balances, you can improve your credit score significantly. The amount of available credit you’re using is called your credit utilization ratio, which makes up 30% of your credit score.
What risks are involved with home equity loans?
These loans are always risky because your home is the collateral. When you get a personal loan, it’s unsecured if you run into financial issues and cannot make the payments, your credit will be damaged, and you may get sued, but you don’t lose any assets. If you’re unable to make your new higher loan payment, you risk facing foreclosure.
When is it a home equity loan a bad idea?
You will be losing the equity you built in your home, so be smart about how you use the funds. Getting a home equity loan to fund a vacation or buy a new car is a big no-no.
You should save up for big purchases that are not related to increasing your home’s value or eliminating high-interest debt.
When is it practical to take out a home equity loan?
The first thing you need is a stable career you’ve had for several years with consistent income. If you can check that box, then a home equity loan makes sense if you want the money to make home improvements, repairs, or renovations that will increase your home’s value.
Paying off high-interest credit card debt is always risky, but you limit that risk with consistent income. Paying off debt at interest rates above 15%-20% with a loan at 6-8% could potentially save you thousands of dollars is a good move as well.
Are home equity loans a good or bad idea?
It really depends on the reason you need the loan. If you’re seeking to pay off credit card debt, I recommend applying for balance transfer credit cards that offer a 0% interest rate for the first 12-18 months.
If you need $10,000-$15,000, you should apply for a personal loan first to see what kind of rates you offered.