We’re often told that one of the biggest reasons to become a homeowner is to pay yourself and not give away our hard-earned money to a landlord.
Now that you’re a homeowner, you may be wondering how to access all that money you’ve kept from a landlord – without selling your home.
The answer: Tap into your home’s equity.
One of the most popular ways to do this is with a home equity loan (sometimes called a second mortgage or home equity installment loan).
“But wait!” you shout. “What is home equity?” you (rightfully) ask.
Home Equity: A Definition
Home equity is the difference in market value between the value of your home and your mortgage balance.
The longer you own your home and make regular mortgage payments, the more equity you build.
How a Home Equity Loan Works: Borrowing Against the House
Equity is based on the value of your home. It’s money you can’t touch until you sell your home.
But if you’re not planning to move, you can take advantage of your home value with a home equity loan.
When you sign up for a home equity loan:
- The lender allows you to borrow a lump sum of money based on how much equity you have available
- You agree to pay back the loan (plus interest) by making regular payments over a fixed period of time
- You agree to put up your home as collateral. If you are unable to pay the loan, the lender has a right to foreclose on the home
How To Get a Home Equity Loan: The Basics
Getting a home equity loan is a lot like getting a mortgage. You’ll submit an application with a lender and go through an approval process. Before you submit that application, here are a few things you need to do:
While a home equity loan is not as involved as a mortgage, the process doesn’t happen overnight. Processing times will vary by lender, but expect a home equity loan application to take 2 – 6 weeks.
During this period, you’ll need to submit all the documentation required by the lender, fill out all the application forms and paperwork and get your home value appraised.
Have enough equity
To be considered for a home equity loan, you need to have a minimum of 15% – 20% equity in your home.
Also, your lender will never lend more than 85% of the current value of your home. Make sure you have enough equity to make the loan worthwhile.
If you put 20% down when you bought your home, you’re probably covered. If you’re still paying for mortgage insurance, you may want to wait before applying.
Have good credit
Lenders will want to take a good look at your finances before approving the loan. This may include:
- Credit score: This will vary by lender, but should be at least 620 (similar to a conventional mortgage)
- Income and employment history: The more you can demonstrate your ability to repay, the better the offered terms
- Debt-to-income (DTI) ratio: Lenders will consider a DTI of up to 43%
The better your credit, the better the interest rate the lender can offer. So before you apply:
- Pay down any high-interest debts
- Look for ways to improve your credit score and clean up your credit report
- Be ready to provide proof of income, especially if you’re self-employed or have income sources that don’t come with a W-2s or 1099s
Be ready to pay
You’ll also be responsible for the closing costs for your home equity loan. While they vary by lender, they may include home appraisal costs, document preparation costs, attorney fees and other expenses. You may need to pay some of these fees upfront. Other fees can be added to your home equity loan. Either way, expect to pay an additional 2% – 5% of the loan amount.
How To Know What Your Home Is Worth: Work Out Its Value
If you want to know how much you can borrow, it’s helpful to know your home’s value. Before you submit your application, research your home’s value online or hire a home appraiser.
Your lender will also require an appraisal by someone of their choosing, but having your own assessment can be helpful, especially if there’s a big difference in the presented appraisal values.
Automated valuation model (AVM): Online research
The AVM uses mathematical modeling to compare and contrast local property values against sales data. With that, the model estimates a property’s expected market price. Its accuracy depends on the model and having accurate data, so be ready to pay a little extra for a professional AVM service.
Competitive market analysis (CMA): Ask a real estate agent
Real estate agents have access to professional tools they can use to price properties for listing. If you know a friendly real estate agent, they may be able to provide you with a CMA at little to no cost.
You may want to thank them by referring a few friends or using them as the listing agent when you sell your home.
House Price Index (HPI) Calculator: Ask the government
The U.S. government is ready to help with the Federal Housing Financing Agency’s House Price Index (HPI) Calculator. Using millions of real estate transactions in your area, it estimates the change in your home’s value over a period of time.
It’s not going to be neighborhood- or ZIP code-specific, but it’s quick, free and unbiased.
Full appraisal: The human factor
This was probably the method used when you first got your mortgage – and the most accurate. In addition to pulling information from an AVM, a professional appraiser will visit your home and perform a full inspection.
Broker’s price opinion (BPO): The drive-by method
This method falls between an AVM and a full walk-through appraisal. The appraiser will use the AVM as their baseline and then drive to your home and take photos to assess the condition of your property and neighborhood.
If you’re planning on getting an estimate, make sure you mow the lawn and trim the hedges. It could help drive up your equity.
Things To Do With a Home Equity Loan
Once you take out a home equity loan, the money is yours.
Take it to Vegas or convert it to cash (the choice is yours). As long as you make your loan payments, you’re golden.
That said, all reasons to use money from a home equity loan are good, but some reasons are better than others. The most common uses are:
Home improvement: Repair, refit or renovate
The most common use of a home equity loan is to put the money back into the home. Money can be used to make repairs, put in a new kitchen or bath or convert the garage into a playroom or man cave.
By investing the money you borrow in your home, you’re adding to the value of your home (which helps you build more equity).
You’ll appreciate that when you sell your home or maybe borrow against it in the future.
Debt consolidation: Say ta-ta to credit card debt
You can use your home equity loan to pay off credit card debt. You’ll save on interest and free up cash for other expenses.
Emergency fund: Extra money for a rainy day
If you want to have money available for emergencies, it may make sense to take out a home equity loan and then park the money in a high-interest account, like a money market account. That way, the money is available when you need it.
Education: Investing in the future
Education is valuable and can cost a lot of money. Whether it’s pre-K, private elementary or secondary school or college, you could use home equity to help pay for a kid’s education.
If you don’t make your payments, you may wind up with an educated child and no roof over your head.
That’s why many financial experts recommend student loans over home equity loans since both have similar interest rates and repayment schedules.
Other reasons: Vacays, celebrations and investments
In the past, homeowners used home equity loans to pay for vacations, weddings, other miscellaneous expensive celebrations, or to invest in a business or investment opportunity.
Recently, using home equity for these kinds of expenses has fallen out of favor. People are increasingly worried about risking their home over something that may not provide a return on their investment.
Pros and Cons Of Home Equity Loans
Like everything in life, there are pros and there are cons. Same goes for home equity loans.
- Easier to qualify for than many other consumer loans
- Offer lower interest rates compared to credit cards and personal loans
- Longer terms give you more time to pay off your loan
- No restrictions on when and how you use the money
- Fixed interest rate and monthly payments make it easier to budget
- Adds to your current debt
- 2 – 6-week process means you have to wait for your money
- You risk losing your home if you can’t make your payments
- If you sell your home, you have to repay the loan with the proceeds – even if your home has lost value
Home Equity Loan Interest: It’s Tax Deductible … But
Before 2017, the answer was YES! You could deduct home equity loan interest for any reason.
In 2017, the Tax Cuts and Jobs Act changed the rules and limited the deduction.
Now, the mortgage interest is only deductible if the loan is used to buy, build or improve a primary residence or second home.
The law also set limits on the total mortgage debt from which you could deduct interest.
These rules are subject to change. You should talk to a tax professional about the benefits of a home equity loan.
Other Ways To Access Home Equity
While a home equity loan is one of the most common ways to access the equity in your home, it isn’t the only way. Depending on your situation you may also want to consider:
Home equity line of credit (HELOC)
A home equity line of credit (HELOC) is similar to a home equity loan.
The key difference is how you access the money. While a home equity loan gives you a lump sum payment, a HELOC works more like a credit card. You can borrow money in smaller amounts. Once you pay your balance, you can continue to borrow against your equity.
A cash-out refinance is essentially a new mortgage.
Assuming you’ve built up equity in your home, you can borrow more than you owe. You’ll need to maintain 20% equity, but once you’ve done that, any money leftover is yours to use as you see fit.
Unleash the Power of Your Home Equity – Responsibly
From renovation to education to retirement, you can do a lot with a home equity loan.
The challenge is to make sure that you’re using the money in a way that builds value over time and allows you to take advantage of your home while keeping a roof over your head.
Internal Revenue Service. “Interest on Home Equity Loans Often Still Deductible Under New Law.” Retrieved October 2021 from https://www.irs.gov/newsroom/interest-on-home-equity-loans-often-still-deductible-under-new-law