If your home is worth more than you originally paid for it – you’ve got home equity. One popular way to access your equity is through a home equity loan. The loan allows homeowners to leverage their real estate assets to expand their buying power and achieve financial goals.
If you could use more buying power as prices continue to reach new highs, we’ll explain how home equity loans work and why and when it may be worthwhile to apply for one.
How Do Home Equity Loans Work?
Your home equity is the difference between your home’s current value and your outstanding mortgage balance. A home equity loan (also known as a second mortgage) is a loan secured by your property.
- You receive the loan in one lump sum.
- The loan’s interest rate is typically fixed, and you pay your lender back in monthly installments over 5 – 20 years.
- The longer the loan term is, the more interest you’ll pay over time.
How Do You Calculate Your Available Equity?
Your home equity is the difference between what you owe and what your home is worth. But lenders typically cap how much equity you can borrow, allowing homeowners to only borrow up to a certain percentage of their home equity.
Remember, your home equity loan is considered a second mortgage. Lending you less money than you have in equity is less of a risk for a lender. If you default on your original mortgage, lenders assume you’ll prioritize the loan that keeps a roof over your head over your second loan. And because the home equity loan is second to your original mortgage, the lender of the original mortgage will get repaid first if the home goes into default or foreclosure.
How much you can withdraw in equity is determined by your combined loan-to-value (CLTV) ratio. Your CLTV is the total value of the combined number of loans secured by your home.
Let’s say your home is worth $500,000, and you owe $230,000 on your mortgage. That means you have $270,000 in equity in your home. If you want to borrow $100,000 through a home equity loan, here is how your CLTV would be calculated:
- $230,000 + $100,000 = $330,000.
- $330,000 / $500,000 = .66, or a CLTV of 66%.
Lenders typically require your CLTV to be no more than 75% – 85%. So if your lender caps your CLTV at 75%, you won’t be able to borrow more than a combined $375,000 (that would mean a maximum home equity loan of $145,000 in this example).
What Are the Interest Rates on Home Equity Loans?
Interest rates are the price you pay to borrow money. And the interest rate you’re offered on a home equity loan will be impacted by the federal funds rate and your credit history, debt and income.
As a rule, home equity loans have fixed interest rates. The rates are usually slightly higher than mortgage interest rates – but significantly lower than personal loan and credit card rates. The loan’s relatively low interest rates are one of the main reasons homeowners take advantage of home equity loans when they need money.
When Should You Take Out a Home Equity Loan?
Depending on your goals, finances and the amount of equity in your home, a home equity loan may be the right option for you. Homeowners typically use the money from their home equity loans to:
Pay for home improvement projects
Home improvement projects can help boost your home’s value and curb appeal – and they can be quite expensive. Upgrading your kitchen or flooring can easily set you back thousands, even tens of thousands of dollars.
Most homeowners don’t have that kind of money on hand. A home equity loan is a savvy way to turn your equity into cash for renovation projects.
Invest in real estate
Saving up enough money to purchase another property can take years. But if you have enough equity in your home, you can leverage it toward a real estate investment property.
Whether it’s a fix-and-flip, a long-term rental, a vacation rental or a wholesale property, you can use a home equity loan to invest in real estate.
Ideally, the rental income or proceeds from the sale of the property would help cover your monthly payments or pay off the home equity loan.
You can use a home equity loan to consolidate debt. If you’re managing lots of loans or credit cards and would like to bundle them into a single loan with one monthly payment, a home equity loan may be a good, low-interest choice.
Make small business purchases
Are you itching to start a business? Are you already your own boss and need cash for business expenses but can’t get a small business loan? You may want to consider exploring a home equity loan.
Pay medical bills
If there is one thing we can count on in life, it’s hospital visits. You can use a home equity loan to pay off large medical bills, but that should be a last-resort strategy.
Pay education expenses
Some homeowners may use a home equity loan to pay for school and school-related expenses if they don’t qualify for student loans or need to supplement their loans. In some cases, it may even make sense to use a home equity loan to pay off student loans.
Reasons To Not Take Out a Home Equity Loan
Home equity loans are best for purchases or investments that “pay” you back. If what you buy doesn’t increase in value or only adds to your debt, you may want to think twice before you use a home equity loan to pay for vacations, weddings or other luxury items.
How To Qualify for a Home Equity Loan
Assuming you have enough equity in your home, lenders will review several factors before deciding whether you qualify for a home equity loan, including:
Credit score and DTI
Your lender will review your credit history and credit score. Your credit score will weigh heavily in your loan application approval. A lender may not feel confident lending money if you have a low credit score because it signals that you’ve had problems managing your debt. You’ll likely pay a higher interest rate if your lender approves you with a less-than-stellar credit score.
Your debt-to-income (DTI) ratio is another number lenders look at to decide whether to approve your loan. If you have a lot of debt and most of your income goes to paying it off, your DTI ratio is probably high. The loan will either be denied or your lender won’t let you borrow as much money.
Consistent payment history
Have you been making your mortgage payment on time? What about your credit card payments? Lenders prefer to see an unbroken track record of payments. A strong payment history is a strong indicator that you’ll repay the money you borrow. Missed payments are red flags that may torpedo your plans.
Pros and Cons of a Home Equity Loan
Like any loan, home equity loans have advantages and disadvantages. Let’s explore their pros and cons in more detail.
Home equity loan interest rates are typically fixed, resulting in predictable monthly payments that never change.
Because home equity loans can have longer repayment terms than personal loans, your monthly payments can be more affordable.
Home equity loan interest rates are usually lower than personal loan or credit card rates.
If you fall behind on your monthly loan payments, you could face foreclosure. You’ll need to decide whether the risk of losing your home is worth taking out a home equity loan.
You’re borrowing against the equity in your home, but you’re still taking out a loan. The loan must be repaid in addition to your original mortgage.
Like mortgages, a home equity loan has closing costs, including an origination fee and home appraisal. The closing costs can range from 2% to 5% of the loan’s value.
Home Equity Loan vs. HELOC: What’s the Difference?
You may have heard of home equity lines of credit (HELOCs). Like a home equity loan, a HELOC is also considered a second mortgage and is another option to access your home’s equity. That said, there are some important differences between home equity loans and HELOCs. While home equity loans provide upfront lump-sum payments, HELOCs operate more like credit cards.
With a HELOC, you receive a line of credit that is a predetermined amount of money you can repeatedly withdraw from up to your borrowing limit during the HELOC’s draw period.
HELOCs typically have variable interest rates, so your interest rate can increase or decrease. And because HELOCs have variable interest rates, your monthly payments can be unpredictable.
If you’d rather withdraw from a line of credit as needed rather than manage a large, lump-sum amount, a HELOC may be worth exploring.
Home Equity Loan vs. Cash-Out Refinance
Another popular way to borrow against your home equity is a cash-out refinance. You refinance the property for what you owe on your mortgage plus what you want to borrow.
With a cash-out refi, you take out a bigger loan that replaces and pays off your original mortgage, leaving you with a new loan with a new term and interest rate. Any money left over is yours to pocket and do as you please.
For example, let’s say your home is worth $400,000. You owe $200,000 on your mortgage, and you want to take $40,000 out of your home equity. If your lender approves you for a $240,000 cash-out refinance, you’ll receive $40,000 at closing.
A cash-out refinance can be a great alternative to a home equity loan if you don’t want to take out a second mortgage. But like a mortgage, you’ll need to meet your lender’s qualifications to refinance.
Home Equity and Purchasing Power
Building equity in your home can potentially supercharge your purchasing power as a homeowner. Whether you need the money for home upgrades, real estate investments or investing in your small business, a home equity loan can be a savvy way to use your home to help you achieve your money goals.
The Short Version
- A home equity loan is considered a second mortgage because it’s secured by your property
- Home equity loan interest rates are typically slightly higher than standard mortgage rates
- Interest on a home equity loan may be tax deductible if you use the money for home renovations and other property improvements or the purchase of a second home