How Home Equity Loans Work—The Pros and Cons
You can borrow against the equity in your home—but be careful
A home equity loan is a type of second mortgage. Your first mortgage is the one you used to purchase the property, but you can place additional loans against the home as well if you've built up enough equity. Home equity loans allow you to borrow against your home’s value minus the amount of any outstanding mortgages on the property.
Let's say your home is valued at $300,000 and your mortgage balance is $225,000. That's $75,000 you can potentially borrow against. Using your home to guarantee a loan comes with some risks, however.
How Home Equity Loans Work
Home equity loans can provide access to large amounts of money and be a little easier to qualify for than other types of loans because you're putting up your home as collateral.
You can claim a tax deduction for the interest you pay if you use the loan to “buy, build, or substantially improve your home,” according to the IRS.
You’ll probably pay less interest than you would on a personal loan because a home equity loan is secured by your home.
You can borrow a fair bit of money if you have enough equity in your home to cover it. However, some lending institutions may cover your closing costs as part of the loan agreement.
You risk losing your home to foreclosure if you fail to make loan payments.
You’ll have to pay this debt off immediately and in its entirety if you sell your home, just as you would with your first mortgage.
You’ll have to pay closing costs, unlike if you took out a personal loan.
Home Equity Loans vs. Lines of Credit (HELOCs)
You've most likely heard both "home equity loan" and "home equity line of credit" tossed around and sometimes used interchangeably, but they're not the same.
You can get a lump sum of cash upfront when you take out a home equity loan and repay it over time with fixed monthly payments. Your interest rate will be set when you borrow and should remain fixed for the life of the loan. Each monthly payment reduces your loan balance and covers some of your interest costs. This is referred to as an amortizing loan.
You don't receive a lump sum with a home equity line of credit (HELOC), but rather a maximum amount available for you to borrow—the line of credit—that you can borrow from whenever you like. You can take however much you need from that amount. This option effectively allows you to borrow multiple times, something like a credit card. You can make smaller payments in the early years, but at some point, you must start making fully amortizing payments that will eliminate the loan.
A HELOC is a more flexible option because you always have control over your loan balance—and, by extension, your interest costs. You'll only pay interest on the amount you actually use from your pool of available money.
Interest rates on HELOCs are typically variable. Your interest charges can change for better or worse over time.
But your lender can freeze or cancel your line of credit before you have a chance to use the money. Most plans allow them to do this if your home's value drops significantly or if they think your financial situation has changed and you won't be able to make your payments. Freezes can happen when you need the money most and they can be unexpected, so the flexibility comes with some risk.
Repayment terms depend on the type of loan you get. You'll typically make fixed monthly payments on a lump-sum home equity loan until the loan is paid off. With a HELOC, you might be able to make small, interest-only payments for several years during your “draw period" before the larger, amortizing payments kick in. Draw periods might last 10 years or so. You’ll start making regular amortizing payments to pay off the debt after the draw period ends.
How to Get a Home Equity Loan
Apply with several lenders and compare their costs, including interest rates. You can get loan estimates from several different sources, including a local loan originator, an online or national broker, or your preferred bank or credit union.
Lenders will check your credit and might require a home appraisal to firmly establish the fair market value of your property and the amount of your equity. Several weeks or more can pass before any money is available to you.
Lenders commonly look for and base approval decisions on a few factors. You'll most likely have to have at least 15% to 20% equity in your property. You should have secure employment—at least as much as possible—and a solid income record even if you've changed jobs occasionally. You should have a debt-to-income (DTI) ratio, also referred to as "Housing Expense Ratio", of no more than 36%, although some lenders will consider DTI ratios of up to 50%.
If You Have Poor Credit
Home equity loans can be easier to qualify for if you have bad credit because lenders have a way to manage their risk when your home is securing the loan. That said, approval is not guaranteed.
Collateral helps, but lenders have to be careful not to lend too much or they risk significant losses. It was extremely easy to get approved for first and second mortgages before 2007, but things changed after the housing crisis. Lenders are now evaluating loan applications more carefully.
All mortgage loans typically require extensive documentation, and home equity loans are only approved if you can demonstrate an ability to repay. Lenders are required by law to verify your finances, and you'll have to provide proof of income, access to tax records, and more. The same legal requirement doesn't exist for HELOCs, but you're still very likely to be asked for the same kind of information.
Your credit score directly affects the interest rate you'll pay. The lower your score, the higher your interest rate is likely to be.
The Loan-to-Value Ratio
Lenders try to make sure that you don’t borrow any more than 80% or so of your home’s value, taking into account your original purchase mortgage as well as the home equity loan for which you’re applying. The percentage of your home's available value is called the loan-to-value (LTV) ratio, and what's acceptable can vary from lender to lender. Some allow LTV ratios above 80%, but you will typically pay a higher interest rate.
How to Find the Best Home Equity Lender
Finding the best home equity loan can save you thousands of dollars or more. Shop around to find the best deal. Different lenders have different loan programs, and fee structures can vary dramatically.
The best lender for you can depend on your goals and your needs. Some offer good deals for iffy debt-to-income ratios, while others are known for great customer service. Maybe you don't want to pay a lot, so you'd look for a lender with low or no fees. The Consumer Financial Protection Bureau recommends choosing a lender on these kinds of factors, as well as loan limits and interest rates.
Ask your network of friends and family for recommendations with your priorities in mind. Local real estate agents know the loan originators who do the best job for their clients.
Be aware of certain red flags that might indicate that a particular lender isn't right for you or might not be reputable:
- The lender changes up the terms of your loan, such as your interest rate, right before closing under the assumption that you won't back out at that late date.
- The lender insists on rolling an insurance package into your loan. You can usually get your own policy if insurance is required.
- The lender is approving you for payments you really can't afford—and you know you can't afford them. This isn't a cause for celebration but rather a red flag. Remember, the lender gets to repossess your home if you can't make the payments and you ultimately default.
You'll also want to be sure that this type of loan makes sense before you borrow. Is it a better fit for your needs than a simple credit card account or an unsecured loan? These other options might come with higher interest rates, but you could still come out ahead by avoiding the closing costs of a home equity loan.
Taxpayers were able to claim an itemized deduction for interest paid on all home equity loans in tax years up to and including 2017. That deduction is no longer available as a result of the Tax Cuts and Jobs Act unless you use the money to "buy, build or substantially improve" your home, according to the IRS.
Consider waiting a while if your credit score is less than ideal if possible. It can be difficult to get even a home equity loan if your score is below 620, so spend a little time trying to improve your credit score first.
Alternatives to Home Equity Loans
You do have some other options besides credit cards and personal loans if a home equity loan doesn't seem like the right fit for you.
This involves replacing your existing mortgage with one that pays off that mortgage and gives you a little—or a lot of—extra cash besides. You would borrow enough to both pay off your mortgage and give you a lump sum of cash. As with a home equity loan, you'd need sufficient equity, but you'd only have one payment to worry about.
These mortgages are tailor-made for homeowners age 62 or older, particularly those who have paid off their homes. Although you have a few options for receiving the money, a common approach is to have your lender send you a check each month representative of a small portion of the equity in your home. This gradually depletes your equity, and you'll be charged interest on what you're borrowing during the term of the mortgage. You must remain living in your home or the entire balance will come due.