A home equity loan is a type of second mortgage in which you borrow against the value of your home, above the remaining amount of any other mortgage on the property.
How do home equity loans work?
Home equity loans can provide access to large sums of money and are slightly easier to qualify for compared to other types of loans because you are putting your home up as collateral. Let’s say your home is worth $300,000 and your mortgage balance is $225,000. You could borrow $75,000 (although in reality, it will be a bit less due to the loan-to-value ratio). However, using your home as collateral for a loan comes with some risks.
Loan-to-Value Ratio
Lenders typically do not allow you to borrow more than about 80% of your home’s value, considering your original mortgage plus the potential home equity loan. The percentage of the available value of your home is referred to as the loan-to-value (LTV) ratio. When looking at the first and second mortgages, lenders will want to know the combined LTV for both loans. Acceptable percentage ratios for LTV can vary from lender to lender. Some lenders allow combined LTV ratios of up to 85% or higher, but you will typically pay a higher interest rate.
Home Equity Loans vs. Home Equity Lines of Credit (HELOCs)
You may have heard the terms “home equity loan” and “home equity line of credit” used interchangeably, but they are not the same thing.
When you obtain a home equity loan, you receive a lump sum of cash and pay it back over time with fixed monthly payments. Your interest rate is determined at the time of borrowing and should remain constant throughout the life of the loan. Each monthly payment reduces your loan balance and covers some interest costs. This is referred to as a “decreasing loan.”
With a home equity line of credit (HELOC), you do not receive a lump sum of cash upfront. Instead, you are given a maximum amount of money you can borrow – a line of credit – that you can draw from at any time you want. This effectively allows you to borrow multiple times, similar to a credit card. You can make smaller payments in the initial years, but at some point, the draw period ends and you must start making full repayment payments that will pay off the loan.
How to Get a Home Equity Loan
Apply with multiple lenders and compare their costs, including interest rates. You can get loan estimates from various sources, including a local lender, an online or national broker, or your preferred bank or credit union.
Lenders will check your credit and may require a home appraisal to determine the fair market value of your property and your equity in it. It can take several weeks or more before any cash is available to you.
Lenders typically look for several factors when making approval decisions, including:
- You are likely to have at least 15% to 20% equity in your property.
- You should have a stable job – at least as much as possible – and a strong income history even if you change jobs from time to time.
- Your debt-to-income (DTI) ratio, also known as your housing expense ratio, should not exceed 36%, although some lenders may consider DTI ratios of up to 50%.
If You Have Bad Credit
It may be easier to obtain a home equity loan if you have bad credit, as lenders have a way to manage risk when your home is collateral. However, approval is not guaranteed.
Typically
All mortgage loans require extensive documentation, and home mortgage loans are only approved if you can prove your ability to repay. Lenders must comply with the law and verify your financial situations, and you will need to provide proof of income, access to tax records, and other documents. There is no same legal requirement for home equity lines of credit, but you are likely to be asked for the same type of information.
How to Choose the Best Lender for a Home Mortgage
The best lender can depend on you and your goals and needs. Some offer good deals for questionable debt-to-income ratios, while others are known for great customer service. You may not want to pay too much, so you might look for a lender with low or no fees. The Consumer Financial Protection Bureau (CFPB) recommends choosing a lender based on these factors as well as loan limits and interest rates.
Ask your network of friends and family for recommendations that consider your priorities. Local real estate agents know which lenders do the best job for their clients.
Buyer Beware
Be aware of some red flags that may indicate that a particular lender is not right for you or may not be trustworthy:
- The lender changes the loan terms, such as the interest rate, at the last minute before closing, assuming you won’t back out at that late time.
- The lender insists on including an insurance package in the loan. You can usually get your own insurance policy if insurance is needed.
- The lender agrees to payments that you cannot actually afford – and you know you cannot afford them. This is not a reason to cheer but a red flag. Make sure you can afford your monthly payments by crunching the numbers first.
Alternatives to Home Mortgages
You have some other options besides credit cards and personal loans if a home mortgage loan does not seem suitable for you.
Cash-Out Refinancing: Cash-out refinancing involves replacing your current mortgage with another mortgage that pays off that mortgage and gives you an additional amount of cash. You will borrow enough to pay off your mortgage and give you a cash amount. As with a home mortgage loan, you will need enough equity, but you will only have one payment to worry about.
Reverse Mortgage: These mortgages are specifically designed for homeowners who are 62 years or older, especially those who may have already paid off their homes. While you have some options for receiving cash, the common method is for the lender to send you a check each month that represents a small portion of your equity in the home. This gradually depletes your ownership rights, and interest will be charged on what you borrow during the mortgage period. You must continue to live in your home; otherwise, the remaining amount must be paid in full.
Frequently Asked Questions (FAQs)
How long do home mortgage loans last?
Home mortgage loan durations vary. You can typically find home mortgage loans ranging from five to 30 years, depending on your needs and financial situation.
How many home mortgage loans can I get?
It is possible to have more than one home mortgage loan on your home, but it can be challenging. You will need to have enough equity in your home to support the primary mortgage and multiple additional loans. Additionally, many lenders may not want to be third in line for payment if you encounter financial issues.
What can home mortgage loans be used for?
You can use a home mortgage loan for almost anything, but not every potential use is financially wise. In many cases, people use home mortgage loans to pay for major home renovations, fund their children’s education, or pay off high-interest debt.
Sources
Used
The Balance only sources high-quality materials, including peer-reviewed studies, to support the facts found in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and credibility of our content.
Source: Federal Trade Commission Consumer Information
Source: Signature Federal Credit Union
Source: Consumer Financial Protection Bureau
Source: Consumer Financial Protection Bureau
Source: Wells Fargo
Source: https://www.thebalancemoney.com/what-is-a-home-equity-loan-5271056
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