What is a home equity loan?
When you take out a home equity loan, there are two ways to receive the cash:
- Lump-sum payment. You take out a large amount of cash upfront and repay the loan over time at a fixed interest rate. This option is ideal if you have a large, immediate expense. It also comes with the stability of predictable second-mortgage payments.
- Line of credit. Once you’re approved for a maximum loan amount, you can borrow as much as you need whenever you want, up to the credit limit. This option, known as a home equity line of credit, or HELOC, gives you flexibility to borrow money as you need it but typically come with variable interest rates. Your payments are lower initially then become fully amortizing later in the loan term. (We’ll cover HELOCs in more detail later.
Home equity loans can help you pay for big expenses like a home renovation, high-interest debt consolidation or college expenses. If you need a large amount of cash, you may want to consider borrowing some of the equity you have built up in your home. But you should do so with care.
How do home equity loans work?
Once you get a home equity loan, your lender will pay out a single lump sum. Once you’ve received your loan, you start repaying it right away at a fixed interest rate. That means you’ll pay a set amount every month for the term of the loan, whether it’s five years or 15 years.
Use Bankrate’s home equity loan rates table to see current rates.
How to calculate your home’s equity
Home equity is the difference between your home’s current market value and your mortgage balance. Here’s how to calculate how much home equity you have:
- Get your home’s current market value. What you paid for your home a few years ago or even last year may not be its value today. You can use online real estate tools, but consider talking to a local real estate agent. A lender will order a professional property appraisal to determine your home’s market value.
- Subtract your mortgage balance. Once you know the market value of your home, subtract the amount you still owe on your mortgage and any other debts secured by your home. The result is your home equity.
Are you eligible for a home equity loan?
To qualify for a home equity loan, here are some minimum requirements:
- Your credit score is 620 or higher — 700 and above will most likely qualify.
- You have a maximum loan-to-value ratio, or LTV, of 80 percent — or 20 percent equity in your home.
- You have a documented ability to repay your loan.
- An approximate figure for how much you want to borrow.
Lenders have varying borrowing standards and rates for home equity products, so you’ll want to shop around for the best deal.
If your credit score is lower than 620, it may be difficult to qualify for a home equity loan. You can check your credit score for free on Bankrate.
Lenders will check your financial documentation, credit score, debt-to-income ratio, income and employment to ensure you can repay the loan. It’s best to have all this available beforehand.
It helps to know how much you want to borrow and what you’re using the money for. Home equity loans are long-term loans that take years to repay so don’t borrow more than you need, only using it for major financial reasons.
The pros of a home equity loan
Home equity loans can be a useful tool when you need a large amount of cash upfront. They have their benefits, like:
- Lower interest rates. Your home is what makes your home equity loan secure. They have lower interest rates than other types of unsecured debt, such as credit cards or personal loans. This can help you save on interest payments and improve monthly cash flow if you need to lower high-interest debt.
- Stable monthly payments. With a fixed-rate home equity loan, you don’t have to worry about your payments fluctuating over time.
- Tax benefits. The 2017 Tax Cuts and Jobs Act allows homeowners to deduct the mortgage interest on a home equity loan if the money is used “buy, build or substantially improve” the home that secures the loan.
Cons of a home equity loan
While a great idea, home equity loans don’t work for everyone. Drawbacks include:
- Borrowing costs. Some lenders charge fees for a home equity loan. As you shop lenders, pay attention to the loan’s annual percentage rate (APR), which includes the interest rate plus other loan fees. If you roll these fees into your loan, you’ll likely pay a higher interest rate.
- Risk of losing your home. Home equity debt is secured by your home, so if you fail to make payments, your lender can foreclose on it. If housing values plummet, you could wind up underwater, meaning you owe more on your home than it’s worth. Your credit and finances could take a major hit, too.
- Misusing the money. You should only use a home equity loan for expenses that will pay you back, like a home renovation that increases value, paying for college, starting a business or consolidating high-interest debt. Stick to needs versus wants; otherwise, you’re perpetuating a cycle of living beyond your means.
Alternatives to home equity loans
Home equity loans can be a great financial resource, not everyone qualifies for one. Here are some other options.
How HELOCs work
A home equity loan isn’t the only type of loan that allows you to tap your home’s equity for cash. A HELOC offers another way to tap your home’s value.
A HELOC works more like a credit card that lets you withdraw on a line of credit up to a certain limit during an initial “draw” period. You’ll be able to pull money anytime you need it during this period, usually 10 years. As you pay down the HELOC principal, the credit revolves and you can use it again. This flexibility, while helpful, means you could pay significant interest charges if you take out a variable-rate HELOC and rates rise.
You can choose one of two loan options: interest-only payments, or a combination of interest and principal payments. The latter helps you pay off the loan more quickly. Most HELOCs come with variable rates, meaning your monthly payment can go up or down over the loan’s lifetime. Some lenders now offer fixed-rate HELOCs, but these tend to have higher initial interest rates.
After the draw period, you enter the repayment period in which any remaining interest and the principal balance are due and the interest rate becomes fixed. Repayment periods tend to be longer than draw periods — anywhere from 15 to 20 years. Using a HELOC for a substantial home improvement project may also be tax-deductible under the new tax law, too.
Home equity loans vs. HELOCs
|Home equity loan||Home equity line of credit (HELOC)|
|Type of interest:||Fixed rate||Variable rate|
|Repayment term:||5 – 15 years||15 – 20 years|
|Payout:||Lump sum||Revolving credit|
|Type of loan:||Secured||Secured|
|Best for:||Debt consolidation, major renovation costs||Minor renovation costs over a number of years|
Personal loans as an alternative to home equity loans
If you don’t own a home or you have other needs you want to use the money for, you may consider getting a personal loan instead.
Personal loans are available through online lenders, banks and credit unions. The best personal loan lenders have competitive interest rates, low to no fees and flexible repayment terms. You can use a personal loan for anything, like consolidating credit card debt, paying for a wedding, moving or other personal reasons.
The best way to qualify for a personal loan is to have a great credit score with a steady job and reliable income. The higher your credit score, the more likely you are to qualify for a low-interest loan. The lower your credit score, the higher your interest rate, which means the higher your overall loan repayment.
Having a low credit score may disqualify you from getting approved for a loan. If that’s you, consider enlisting the help of a cosigner.
How to get a home equity loan with bad credit
If your bad credit history is holding you back from qualifying for a home equity loan, there are a few things you can do to fix it.
- Build up your credit score. At the very least, your credit score should be 620. Pull your credit report, dispute any errors with the credit bureaus showing the mistakes and look at problem areas. If you have unpaid loans, start paying them off. If you have high credit card debt, at least make minimum monthly payments. Settle any old debts that are keeping your score down.
- Consider going local. Many online lenders will work with you and your low score, but if you keep getting rejected, try a credit union. Credit unions tend to be more likely to consider your individual case. The face time will only help you.
- Find a cosigner. A cosigner is someone who agrees to pay back the loan in case you don’t. They’re great for qualifying and even getting a low interest rate, but keep in mind the responsibility. While staying on top of your loan can boost your credit score (and theirs), failing to repay your loan means your credit score will tank — and so will theirs.