What is a home equity loan? Can you use a home equity loan for anything? Find out more about this by reading the article now
Because of its flexibility, a home equity loan can help you in any number of ways, from paying off a student loan to funding home improvements to bolstering an emergency fund. Like any other loan, however, a home equity loan can also come with downsides.
Here is everything you need to know about a home equity loan: What it is and should you use it. for our usual audience of mortgage professionals, this is part of our client education series. We encourage you to pass this along to clients who may have questions about home equity loans.
What is a home equity loan?
A home equity loan—also known as a second mortgage, an equity loan, or a home-equity installment loan—is a loan you take out against the value of your home. Home equity is the portion of your property that you have paid off, i.e., your stake in the home versus your lender’s. Home equity is, in other words, the appraised value of your property minus any outstanding loan and mortgage balances.
A formula that would help you determine your home equity might look like this:
Home value – minus loan balance = home equity.
You can take out a home equity loan for any number of reasons, but they are typically used to help secure money for a home renovation, to consolidate debt, or to help with any other financial goals. Available for both non-residential and residential properties, the loan amount for a home equity loan is calculated by the current market value of the home.
Additionally, there are two main types of home equity loans:
- Home equity loans
- Home equity lines of credit (HELOCs)
Home equity loans and home equity lines of credit differ in how you receive the money and how you repay the loan. To give you a better idea of the differences and the nuances of each, let’s take a closer look at both types of home equity loans:
1: Home equity loans
A home equity loan is essentially a second mortgage, which means a debt secured by your home beyond your initial mortgage. A home equity loan is paid to you as a lump sum, and after you have received the loan, you begin repaying it immediately at a fixed interest rate, meaning you repay an arranged amount each month for the life of the loan, whether that is five, 10, or 30 years.
If you have a significant, and pressing, expense, a home equity loan may be ideal. Home equity loans are also stable due to the consistent monthly payments.
2: Home equity lines of credit (HELOCs)
A home equity line of credit, or HELOCS, functions similarly to a credit card, giving you the ability to withdraw as much money as you want up to the credit limit during the draw period, which is often up to 10 years. Your credit revolves allowing you to reuse it as you pay down the HELOC principal, which also provides you with the flexibility to get the funds that you require.
You also have the option to select interest-only payments or combine principal and interest payments, which would be more beneficial if you need to repay the loan fast. Typically, HELOCs are offered at variable rates, which means that your monthly payments may decrease over the life of the loan, depending on market fluctuations. While lenders do offer fixed-rate HELOCs, they usually carry a higher initial interest rate and occasionally an extra fee.
When the draw period ends, you have to pay the remaining principal balance and interest. Usually, repayment periods are between 10 and 20 years. And if you are using the HELOC for a substantial home renovation, the interest on it may be tax deductible, so it is important to understand the conditions of your HELOC—and potential benefits.
HELOCs are popular amongst younger homeowners right now.
Beyond home equity loans and HELOCs, there are two other primary ways to borrow equity, which includes:
- Reverse mortgages
- Cash-out refinancing
Here is a closer look at each:
1: Reverse mortgages
Another way to use your home equity, you can take out a reverse mortgage—if you are 62 years old and older. (With some products, that age can drop to 55 years old and older.) If you own your home outright, or have a significant amount of equity built up, you can use a reverse mortgage to withdraw a portion of that equity.
If you use a reverse mortgage, you can also avoid having to repay the loan in monthly instalments, unlike a home equity loan or a HELOC; lenders instead pay you every month while you live in the house. When the borrower passes away, sells the home, or moves out, then the reverse mortgage loan has to be repaid. Many borrowers site the desire to retire as a reason to go this route.
2: Cash-out refinancing
Cash-out refinancing means to replace your current home loan with a larger loan, which includes a portion of your home equity, withdrawn as cash, and the balance you owe on your existing mortgage. You can use cash-out refinancing for any reason.
You also may be able to get a lower rate on your main mortgage, depending on market conditions, and shorten your loan term so you can pay it off faster. These factors are unique to cash-out refinancing compared to home equity loans or HELOCs.
What is the difference between a home loan and a home equity loan?
Home loans and home equity loans function similarly in that the property serves as collateral in both cases. One significant difference between a home loan and a home equity loan is that the eligible loan amount for a home loan is typically up to 90% of the market value of the property. For a home equity loan, on the other hand, you convert the equity on your property into money. Repayments include payments on the principal as well as the interest.
How does getting a home equity loan work?
In order to get a home equity loan, you will first need to qualify. To determine whether you qualify for a home equity loan, your lender will look at these three factors:
- Your equity
- Your credit score
- Your debt-to-income ratio (DTI)
If you are weak in one of these areas—as in, you have a poor credit score, for instance—you may be able to rely on the other two to help boost your chances—and qualifications. Let’s take a closer look at each to better understand what lenders are looking for.
1: Your equity
A lender will get an appraisal on your home to determine if you qualify and how much money you may be able to borrow. In other words, the lender will order a home appraisal to see how much your property is worth.
Most lenders will allow you to borrow around 90% of the equity in your property. You can calculate your loan-to-value ratio to determine the amount you can borrow using a home equity loan. To calculate your loan-to-value ratio, you subtract the balance of your primary mortgage from 90% of the appraised value of the property.
Here is an example of the formula to determine your loan-to-value ratio:
$400,000 (appraised value of property) x 0.9 (90%) = $360,000 (loan-to-value ratio)
And here is an example of using that loan-to-value ratio to calculate your potential loan amount:
$360,000 (loan-to-value ratio) - $100,000 (remaining balance of mortgage = $260,000 (potential loan amount)
2: Your credit score
Your credit score plays a significant role in determining whether you qualify for a home equity loan, especially because it gives lenders a glimpse into your credit history. Generally, if you have a higher credit score, you will benefit from a lower interest rate. You should have a credit score of at least 620 if you want to get a home equity loan. Because there are exceptions to this rule, you should research to see what you may be able to qualify for.
3: Your debt-to-income ratio
Lenders calculate your debt-to-income ratio (DTI) to determine whether to approve you for a home loan. DTIs compare your monthly income against your monthly debt payments, which helps lenders decide if you can afford to take on more debt burden.
Usually, your DTI should be 45% or lower in order to qualify for a home equity loan. You can calculate your DTI yourself using this equation:
Monthly debt payments / gross monthly income = DTI
Here is a breakdown to calculating your DTI:
- Add up your monthly debt payments, which usually includes credit card, student loans, car loans, your primary mortgage, child support, and alimony, among others
- Divide your monthly debt payments with your gross monthly income, i.e., the money you earn every month before deductions and taxes
- Multiply that number by 100 to determine the percentage.
How to get a home equity loan with bad credit
It is often easier to get a home equity loan instead of a personal loan if you have had previous credit problems, since there is less risk involved for lenders. Why? Because home equity loans are secured by your house. You should know, however, that lenders can foreclose and recoup costs if you can’t make your monthly payments.
Despite a low credit score, your chances of getting approved for a home equity loan are higher if you have built up significant equity in your home and have a DTI on the lower side. However, in this case, your home equity loan would likely come with higher fees and interest rates.
On the other hand, it will be more difficult to get a home equity loan if lenders have reviewed your finances and determined you will be unable to pay back the loan. Since more restrictions on lending have been enacted since the housing crisis, it is important to know home equity loan rates, which depend on credit score, primate rate, credit limits, the lender, and loan-to-value ratios.
What is the downside of a home equity loan?
A home equity loan, like any debt, can come with downsides. If you are undisciplined in your spending, getting a lump sum of money can itself be risky. Then there are the interest rates, which, while low compared to most other forms of debt, are still higher than primary mortgage rates.
Here is a quick look at the downsides of a home equity loan:
- You may be tempted to overspend: Getting tens of thousands of dollars at once can tempt many people to overspend. It is therefore crucial that you are aware of your spending habits, for better or worse. Many experts suggest that you avoid spending the money on daily living expenses or luxuries (expensive car or boat). Remember: if you default on the loan, your home will be at risk.
- They are more costly than primary mortgages: Home equity loans come second to your primary mortgage, meaning that if you are unable to make payments, your home equity lender is next in line behind your primary mortgage. For this reason, interest rates are a little higher on home equity loans.
- The application process can be long and expensive: Unlike applying for a new credit card, for example, taking out a home equity loan can be a time-consuming and somewhat costly process. It can take months for the lender to review your credit history and application.
Home equity loans can also come with fees and closing costs, which means accessing your home equity can come at a cost. It is therefore critical that you speak with your lender to better understand which fees you may be on the hook for.
Can you use a home equity loan for anything?
The short answer is: Yes, pretty much. Typically, the ways that you can use your home equity loan are flexible. However, you should keep in mind that your home equity loan will have to be paid in full if you plan to sell your property in the foreseeable future.
To give you a better idea of their flexibility, here are some common uses of a home equity loan:
- To pay for a student loan
- To consolidate credit card debt (or pay it off)
- To pay for a vacation
- To pay for a wedding (or other celebrations)
- To fund for home improvements and upgrades
- To pay for medical bills
- To make an investment
- To purchase a vehicle
- To save as an emergency fund
As we have seen, there are many uses of a home equity loan. But it is important not to be tempted by the lump sum, especially if you have a history of overspending. To decide whether a home equity loan is right for you, you should first know the different options available for you, whether you qualify, and the potential downsides. If it makes financial sense, you can then reap the rewards.
Do you have experience with a home equity loan? Was it a good idea for you? Let us know in the comment section below.