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If you need cash for a large expense, you might be considering tapping your home equity. Also known as second mortgages, equity loans allow homeowners to borrow money via their home equity — the portion of the home they own outright, calculated as the difference between the home’s current market value and the borrower’s remaining mortgage balance.
Two of the main ways to access your equity are home equity loans and home equity lines of credit (HELOCs). Let’s look into how they work, their pros and cons, and how to apply for one— or both.
- Home equity loans and HELOCs are two common ways to borrow against the value of your ownership stake in your residence.
- Home equity loans offer a lump sum upfront while HELOCs allow you to draw funds multiple times over a period.
- Because they're secured by the value of your home, equity loans tend to be cheaper than other loans, and the interest can be tax-deductible.
- The main drawbacks: Equity loans put your home at risk of foreclosure if you miss payments, and they can be tougher to qualify for.
Equity loans: overview
Equity financing comes in two main forms: Home equity loans and HELOCs. With both, your home acts as collateral for the lender, so if you fail to make the monthly payments, you run the risk of losing it.
Home equity loans operate like mortgages with fixed, monthly payments. HELOCs are lines of credit that typically come with a variable interest rate, though some lenders offer fixed-rate options. Both can be used for any expense, including home improvement projects, financing a college education, and debt consolidation.
With either, the amount you can borrow is generally based on loan-to-value ratio (LTV) or combined LTV ratio (CLTV) — how much you’re borrowing compared to the value of the property — with a typical limit of 80 percent or 85 percent of your equity. Your specific limit might be based on factors such as credit score, annual income and payment history.
Eligibility requirements for equity loans
While criteria can vary by lender, these are the general requirements for a HELOC or home equity loan:
- A debt-to-income (DTI) ratio of no more than 43 percent
- A good credit score, at least in the mid-600s
- A sufficient, steady income
- A history of on-time payments
- At least 15 percent to 20 percent home equity
Pros and cons of equity loans
There are many advantages to equity loans that make them attractive to borrowers, but it’s important to understand their drawbacks too.
- Large borrowing limits. Equity loans can let you borrow large amounts of money. You can get loans for tens or even hundreds of thousands of dollars.
- Low interest rates. Because equity loans are secured (backed) by your home, they tend to have lower interest rates than unsecured forms of debt, like credit cards or personal loans.
- Use money for any purpose. There are very few limits on how you can use the money you borrow.
- Tax benefits. If you use the loan to make qualifying home improvements, repairs or purchases, you might be able to deduct the interest on your taxes.
- Closing costs. Home loans of any type, including equity loans, come with closing costs. These upfront fees can cost thousands of dollars.
- Limited by your ownership stake. How much you can borrow is determined by your home equity. If you don’t own a home, are underwater on your mortgage, or haven’t built much of an equity stake yet (less than 15 percent), you can’t get one of these loans.
- Your home is at risk. Using your home as collateral helps keep the interest rate low, but it means that you’ll be putting your home at risk if you run into trouble and can’t make payments.
- Onerous application. Applying for home equity loans is somewhat akin to applying for a mortgage — often the lender will order up a home appraisal — and it can take several weeks to get approved.
Home equity lines of credit (HELOCs)
A HELOC is an equity line of credit similar to a credit card — you can borrow up to a certain amount and take out however much you need, when you need it, and for any purpose, though if used for home-related repairs or upgrades, they may be tax-deductible. The interest rates on HELOCs are usually variable, but some lenders allow you to convert some or all of your balance to a fixed rate.
Typically, HELOCs have a draw period of 10 years and a repayment period between 10 years and 20 years. During the draw period, you can access the funds and are only required to make interest payments (though you can also repay principal if you choose). During the repayment period, you can’t access the funds any longer, and are responsible for making both interest and principal payments.
Home equity loans
With a home equity loan, you borrow a lump sum, usually at a fixed interest rate. The repayments, which begin promptly and cover both interest and principal, extend over a term between five and 30 years. The loan is backed by your home — or more precisely, the ownership stake you have in it. Home equity loans can also be used to finance any project, investment or purchase. If used for home improvements, the interest might be tax-deductible (more on that below).
Home equity loans vs HELOCs
Home equity loans seem similar to HELOCs, but they are distinctly different ways to borrow money.
|Home equity loan||HELOC|
|Loan terms||5 years to 30 years||10-year draw period; up to 20-year repayment period|
|Repayment||Begins once funds are disbursed||Interest-only payments during draw period; interest and principal payments during repayment period|
|Funding||Disbursed in one lump sum amount||Withdraw any amount, up to the limit, when needed|
|Monthly payments||Same payment every month||Varies based on interest rate and balance owed|
|Pros||Lower rates compared to credit cards and personal loans; potential interest deduction||Can borrow only as much as you need; possible option to convert to fixed rate; potential interest deduction|
|Cons||Can only borrow a fixed sum, which might be more or less than you need; risk of foreclosure if you can’t repay||Variable rate means your payments might go up; risk of foreclosure if you can’t repay|
Home equity loans/HELOCs are not the same as refinances, although both are a form of debt that uses your home as collateral. With the former, you’re borrowing a new sum of money, independent of your existing mortgage. When you refinance, you’re taking out an entirely new mortgage to replace your current one. Generally, refinancing is best for borrowers who can get a lower interest rate or other better terms with the new mortgage. and plan to stay in their home long enough to recoup the closing costs. An equity loan is best for those who want to retain their existing mortgage (typically because they have an attractive rate or have nearly paid it off) but still need funds.
Equity loan tax deductions
While they can be used for any expense, home equity loans and HELOCs. are particularly popular financing methods to renovate, remodel or even purchase a home. That’s because the interest on them is tax-deductible if the funds are used to substantially improve, repair or buy a residence. You must itemize deductions on your tax return to take advantage.
Joint filers can deduct the interest on up to $750,000 of equity loans, if taken out after Dec. 15, 2017. Single filers can deduct the interest on up to $375,000 worth. Joint filers whose loans closed before Dec. 15, 2017 can deduct the interest on up to $1 million, while single filers can deduct the interest up to $500,000.
Note: These deduction limits collectively apply to all of a taxpayer’s mortgages. That means if you were a single filer with a $300,000 primary mortgage and a $75,000 home equity loan, you’d be right at your limit.
What to know before applying for an equity loan
1. Know your worth: home equity and home appraisals
To qualify for an equity loan, many lenders require you to have at least 20 percent equity in your home — in other words, a maximum LTV (or CLTV) ratio of 80 percent.
Note: Calculators can give you a general idea of how much your ownership stake is worth. But a key part of the equation is your home’s current market value. Lenders rely on an appraiser’s estimate of your home’s value to determine how much equity you’re allowed to tap. If you’re just weighing your options, however, you don’t have to hire an appraiser — you can talk to a real estate broker to get a rough idea of the home’s worth and the value of the equity you have.
2. Know your finances: debt-to-income ratio, credit score
Before you apply for an equity loan, you need to get a sense of your financial picture.
One of the first things to do is calculate your debt-to-income (DTI) ratio. This is the percentage of your gross monthly income that goes toward debt repayments.
For example, if you make $5,000 a month and have debt payments equal to $2,000, your DTI ratio is 40 percent. When you apply for an equity loan, lenders will want to calculate what your DTI ratio would be if you took on the new loan. Most look for a DTI ratio of no more than 43 percent, though some might allow up to 50 percent.
It’s also key to check your credit. Though you may still qualify with a lower score, you’ll wind up paying more in fees and interest rates. Most lenders will look for scores of 620 or higher, but 700 is better and 740 or higher is ideal.
The more equity you have and the lower your DTI ratio is, the easier it will be to qualify. If needed, take steps to improve your credit score, such as paying down or paying off debt.
Getting an equity loan with bad credit
If your credit score is less than perfect, you’re not out of luck for an equity loan. The nice thing about using your home as collateral is that it greatly reduces the lender’s risk. That makes it much easier to get an equity loan with poor credit than it is to get many other types of financing.
Another tip to try is to apply for a loan with a lender you already have a relationship with. For example, if you have a checking or savings account at an institution that also offers equity loans, try applying there first. They may cut an existing customer a break.
If your credit score has gotten dinged due to some one-time or temporary reason, you can try writing a letter to your potential lenders explaining why your credit score is (uncharacteristically) low and what steps you’ve taken to improve it — pointing towards your previous good history.
You can also consider getting a friend or family member to co-sign or even act as co-borrower on the application. Bear in mind that, while this could get you over the approval hump, you will have to have at least the bare minimum credit score that the institution requires on your own.
3. Compare home equity lenders
Not every mortgage lender offers home equity products, and to get the lowest rate, it’s crucial to shop around. Many banks provide home equity loans, and increasing numbers of online lenders do, too. To help narrow down your options, review home equity lender reviews and testimonials. Once you find the lender that meets your needs and offers the best rates, check its eligibility requirements to make sure you qualify.
Equity loan payback help
If you’re having trouble making your equity loan payments, contact your lender as soon as possible. Your lender might offer relief like a lower rate, adjusted repayment terms or forbearance options. Don’t wait to miss a payment before contacting your lender — if you do, eventually, you’ll be given a notice that you’re in default and the lender might begin the foreclosure process.
Alternatives to home equity loans
A cash-out refinance is similar to a home equity loan in that you’re tapping into your ownership stake for ready money. But with a cash-out refinance, you are replacing your entire mortgage, exchanging the old loan for a bigger one.The extra amount, which you take in cash, is based on the amount of equity you have built up in your home. However, the terms of your new loan may differ significantly from those of the original.
If you’re a homeowner aged 62 or older, you may be able to take out a reverse mortgage and borrow part of your home’s equity as tax-free income. Your lender will make payments to you, but those payments will need to be repaid when you die, permanently move out or sell the home.
Personal loans pay you money in a lump sum, typically at a fixed interest rate. They are “unsecured,” meaning they have no attached collateral that the lender can seize if you fail to repay. As a result, their interest rates tend to be higher than those of home equity loans, and there’s no possibility of tax deductions for home-related expenditures.
When should you get a home equity loan?
There are several circumstances that getting a home equity loan might be good for.
Many homeowners take out home equity loans to finance large, home-related projects like a kitchen renovation or a new garage. These projects can make a home more comfortable, and when done wisely, will increase the home’s value. Plus, the loan interest will often be tax-deductible. However, you’ll have to make sure that the monthly payments on your additional loan won’t stretch your budget too thin.
A home equity loan can allow you to consolidate high-interest debt at a lower interest rate, or to pay off other personal debts such as car or student loans. The downside is that you’ll turn an unsecured debt into debt that is now backed by collateral — namely, your home. Which means it could be forfeit if you default on your loan.
Financing college with a home equity loan can sometimes be a better deal than using student loans. You’ll save if the interest rates are considerably lower than student loan rates. You may also be able to secure a longer term with lower monthly payments. And, if you take out a HELOC, you can time the withdrawals to when the semester or year’s tuition bills are due, only paying interest on the actual draw. However, a home equity loan is riskier than a student loan by definition, since your home becomes collateral for the debt — and the lender can seize it if you default.
Maintaining an emergency fund to cover three to six months of living expenses is not viable for many Americans. Tapping home equity may be the answer if you have a sudden, unforeseen need or expense, and have no other source of ready money. But the loan application process is time-intensive — not the best if the need is immediate — and taking out a home equity loan can be a direct route to serious debt.
How much do you pay on a home equity loan?
It depends on several things: the length of the loan, the interest rate and the borrower’s financials and location. Let’s say you take out a $75,000 home equity loan on a property in Louisville, KY worth $300,000. You have a credit score of 740, and you have $160,000 remaining on your mortgage.
As of this writing, based on Bankrate’s average home equity loan rate calculator, if you get a loan with a 8.32 percent interest rate and a 30-year term, your monthly payment will be $567. By comparison, you’ll pay $921 per month for a 10-year loan at 8.3 percent interest. And if you opt for a 15-year term with 8.37 percent rate, your payments will be $733 each month. However, you’ll pay substantially less in interest over the life of the loan.
These figures don’t account for additional charges like origination fees, appraisal fees and other closing costs. When choosing a home equity loan, you’ll need to consider these upfront expenses, much as you would with a mortgage. With some lenders, you may be able to snag a lower rate on your home equity loan if you set up automatic payments.
How many years do you have to pay off a home equity loan?
Your repayment period will depend on your loan term, which typically ranges from 5 to 20 years and sometimes even 30 years. Bear in mind: the longer the term, the more you’ll pay in interest over the life of the loan.
Your interest rate and monthly payments will be fixed, so your repayment schedule will be predictable. You should check with your lender first if you want to pay off your loan early. Your loan may include an early payoff penalty.
Bottom line on home equity loans and HELOCs
While putting your home up as collateral can be a risky move, if you can afford the payments, equity loans allow you to borrow large sums of money at relatively lower rates than other forms of financing. If you’re unsure whether to take out a HELOC or a home equity loan, talk to a lender. You might also want to speak with a financial advisor to help determine which option best suits your situation.
Additional reporting by T. J. Porter