Home Equity Loan
A type of loan that homeowners use to borrow money against their home's current equity
What Is a Home Equity Loan?
Home equity loans are an affordable and flexible way for homeowners to borrow money. Unlike a traditional mortgage, these funds are loaned out against the value of your home.
These loans are primarily used to finance home improvements and major purchases and to consolidate debts.
These loans require you to have equity in your home. This equity can be calculated as the difference between what your home is currently worth in the market and the amount you owe on your mortgage:
Current Appraised Home Value - Mortgage Balance = Owner’s Equity
In most cases, the more equity or ownership, the more you can borrow, but this depends on other factors that lenders look at.
Apart from this, lenders, such as your banks, credit unions, or specialized firms, check your credit score, income, & debt-to-income ratio in determining whether to approve your loan application.
The 2 main types of loans you can get are:
1) Fixed Rate Loans: Have a set interest rate and monthly payment
2) Line of Credit Loans: You can borrow as much or as little as you want. It acts very similarly to a credit card.
Because your home is used as collateral to make this method an easy way to borrow money, you could face foreclosure on your home if you miss your payments.
In this article, we will break down these loans:
- How they Work
- Qualifications
- Different Types of Loans
- The Pros & Cons of these loans
If you are confused about the terminology or any concepts about this topic, check out the Wall Street Oasis' financial modeling courses to better understand these ideas!
Key Takeaways
- Home equity loans allow homeowners to borrow against the equity in their home. The equity is calculated as the home's market value minus mortgage debt.
- These loans can be fixed rates with predictable payments or a line of credit with flexible borrowing. The home acts as collateral, so foreclosure is a risk if payments are missed.
- Lenders look for sufficient home equity (typically 20%), good credit, stable income, and a low debt-to-income ratio when approving borrowers.
- Pros include accessible funds and potentially tax-deductible interest. Cons include the risk of foreclosure, high rates, and fees.
- Consider all loan terms and fees using the APR when comparing different lenders. Understand repayment risks before borrowing.
Understanding Home Equity Loan
Home Equity Loans are a type of loan that homeowners use to borrow money against their home's current equity.
The equity you have on your home can be calculated as the difference between the current market value of your home and the mortgage balance:
Current Appraised Home Value - Mortgage Balance = Owner's Equity
These loans are secured (or collateralized) by the home you are borrowing against. If you default on the loan, miss a payment, or fail to follow a loan covenant, the lender (bank, credit union, specialized firm) can foreclose your home to mitigate their losses.
This allows these kinds of equity-based home loans to have lower interest rates in comparison to personal loans or credit cards.
Because they are funds received after your initial (or primary) mortgage, these equity-based home loans are sometimes called "second mortgages."
NOTE
Home Equity Loans differ from home equity line of credit (HELOC) loans. HELOC loans provide a revolving line of credit, whereas home equity loans provide a lump sum of funds.
Examples of what most homeowners take out one of these equity-based home loans to help fund include:
- Retirement
- Medical Bills
- Education Expenses
- Business Start-Up Capital
- Emergency Expenses
- Estate Planning
- Wedding or Special Event
- Retirement
This loan is attractive for homeowners who need to borrow a significant amount of money but comes with inherent risks and qualifications.
How a Home Equity Loan Works
Home Equity Loans are backed by the equity on the homes that borrowers are borrowing against.
The amount of equity that a homeowner has can increase over time in 3 ways:
1) The value of the home appreciates due to upgrades or modifications.
2) The market value of the home increases due to economic conditions.
3) The homeowner pays down the mortgage balance over time, increasing the amount of ownership they have.
Your loan lender will require that you have a certain amount of equity in your home. The minimum is typically around 20% but varies based on the following:
- Home Equity
- Loan
- Credit Score
- Debt-to-Income
- Employment History & Income Level
- Loan Term
- Interest Rates
As mentioned earlier, you receive this amount in a lump sum that you can use however you would like if approved for the loan.
NOTE
Different loan products have different repayment periods. This can range from 5 years to 30 years.
Like other loans, you can refinance this equity-based home loan at any time. This means taking out a new loan (ideally with a lower interest rate, shorter term, or different payment type) to repay the second mortgage.
Some lenders may have prepayment clauses or penalties that could affect your ability to refinance. This clause is usually extra fees that should be paid on top of your loan for early repayment.
Different loan products also offer different interest rates. The interest rate on your loan may be fixed or variable. This, coupled with any fees that may be imposed, can affect the monthly repayments of your loan & depends on the amount you borrow.
The Annual Percentage Rate (APR) is the best way to compare these different loan products. It provides a percentage representing the total cost of the loan (including any fees that may need to be paid).
This can be calculated as:
Your lender may have placed certain penalties or covenants in the terms and conditions of these loans, so you must read the contract before agreeing to it, as they may affect the loan's actual cost.
Types of Home Equity Loans
Earlier, we mentioned how there are 2 main types of loans you can get based on your home's equity. You should understand each loan's unique set of benefits & features to choose one that best suits your financial goals. They are:
1) Fixed Rate Loan
You amortize the loan (paid out as a lump sum) with a fixed-rate interest. This keeps your monthly payments predictable as they are roughly the same throughout the loan's life.
These loans are good for when you need a lump sum upfront for a specific purpose like
- Home improvements,
- Debt consolidation,
- Fund other investments,
Or if you prefer the stability & predictability of a fixed payment schedule.
2) Home Equity Line of Credit Loan (HELOC)
Acts more like a credit card. You get approved for a line of credit you can draw from as needed, up to a certain amount.
NOTE
You only pay interest on the amount you borrow, pay off the loan, and borrow again during the "draw period."
It is a good option if you need flexibility in your borrowing like:
- Ongoing home improvement projects
- Emergency Expenses
- Education Expenses
- Business Expenses
If you don't want the money all at once and want to borrow money as needed.
These loans are secured, meaning they use your home as collateral. If you miss payments or default, you may be forced to foreclose by your lender.
Pros & Cons of Home Equity Loans
Home Equity Loans have many benefits for a second mortgage, but they have risks that should be considered. Here are some of the advantages & disadvantages of this kind of loan.
The pros are:
1. Liquidity
You can easily access large sums of capital (up to 80% of your home's equity). This is good for financing anything that has high up-front costs.
2. Fixed Interest Rates
These loans have fixed interest rates, which provide stability and predictability when budgeting to pay the loan.
3. Taxable income deductions
The interest you pay on a loan may qualify for a deduction from your taxable income. You should check the IRS's webpage to know if this applies to you.
The cons are:
1. Risk to your home
You put your home as collateral, which can lead to a foreclosure if you fail to follow the T&C of the loan.
2. Additional fees
Some lenders charge origination & application fees and may charge prepayment penalties which can increase the loan cost.
3. Higher rates
The interest rate on a loan may be higher than other large loan rates depending on your lender. This can increase your overall borrowing cost.
4. Impact on credit score
This loan can affect your overall debt load, affecting your credit score. In addition, because this increases your DTI, it can potentially be harder for you to get other loans or lines of credit.
5. Overborrowing
Homeowners may be tempted to borrow more than they can afford or need, leading to financial hardship and difficulty making loan payments.
Turning your equity in your home liquid is a good type of loan, but it should be used responsibly and cautiously.
How to Qualify for a Home Equity Loan?
You will need to meet a few prerequisites to qualify to get a loan based on the equity you have in your home. They are:
1) Sufficient home equity
To qualify for this loan, most lenders will require you to have roughly 20% equity. In addition, the value of your home must be greater than the outstanding mortgage balance.
2) Good credit score
Lenders look for a minimum 620 credit score to qualify for this loan. Higher scores result in favorable terms & lower rates.
3) Stable income
Lenders want stable income to ensure they receive their payments on time. Therefore, you will need to provide pay stubs & tax returns to them.
4) Low debt-to-income ratio
Lenders use your debt-to-income ratio to decide whether to approve or deny your application. For example, a lender will look for a DTI lower than 43% to qualify, with the ideal candidate having a DTI less than 36% (According to RocketMortgage).
5) Home Appraisal
Lenders will require an appraisal of your home which helps them understand the current market value and the borrower's equity.
For example, if the housing market is in bad condition and the appraisal value drops below your mortgage value, you will have negative equity.
Whereas if the housing market is booming, the equity you have in your home may exceed the amount you bought the home for.
NOTE
These requirements may vary depending on the lender and the specific loan product you are applying for. Some lenders may have more strict requirements, while others may be more flexible.
Alternatives to Home Equity Loans
These loans are a great way to access the equity you've built in your home, but some may have better options. Here are some alternative options:
1) Personal loans
Personal loans don't require any collateral and can be used for various purposes. They come with higher interest rates & have to be repaid sooner, though.
2) Cash-out refinancing
Cash-out refi allows you to refinance your mortgage. The difference is given in cash to be used for any purpose. It has lower interest rates but may come with fees & closing costs.
3) HELOCS
We've mentioned HELOCs before. They are useful if you have ongoing expenses, like college tuition.
4) Credit Cards
For small improvements or projects, you can use a credit card. Depending on the purchase, they may have rewards or cashback that can be reaped.
NOTE
It's important to carefully evaluate the costs and risks of each option when considering alternatives to equity-based home loans
Everyone has different credit scores, income, & needs. Consider speaking with a financial or mortgage advisor who can help you find a loan product tailored to help you reach your financial goals.
You can also learn more about how different loans & rates affect your overall income through the Wall Street Oasis's Financial Modeling Courses!
Tips For Choosing a Home Equity Loan
It's important to shop around with different lenders when trying to get a home equity loan. Here are some factors to consider to help you pick out the right loan:
1) Shop Around
Comparing interest rates and fees from multiple lenders can help you find the best deal. Make sure to use the APR as it includes both the interest rate & fees in its calculation and provides a standard to compare.
2) Consider the Terms
Choose a loan length and repayment schedule that fits your financial goals & budget. Some loans come with longer repayment terms but have higher interest rates.
3) Account for Fees
Loans may have fees apart from the interest rate, including origination fees, Appraisal fees, & closing costs. You should factor these into your decision using the APR.
4) Check your Credit Score
When a lender decides whether to approve you for a loan or not & determines your terms, the credit score plays a huge role.
5) Understand the Risks
If you fail to repay your loan, you risk losing your home. Therefore, you should evaluate your repayment ability before agreeing to a loan.
You can choose the right type of loan for your needs & goals if you consider these factors. Take your time & do your due diligence before committing to this big financial decision.
Summary
A home equity loan allows homeowners to turn the equity they have in their homes into cash. These loans are predictable to borrow because they come with a fixed interest rate & set repayment term.
To qualify for this loan, a homeowner's equity should be roughly 20% of their original mortgage amount. Other factors like income level, credit score, & debt-to-income ratio can change this percentage.
Two main types of equity-based home loans: fixed-rate loans & HELOC (Home Equity Line of Credit Loans). Fixed-rate loans provide a lump sum of money upfront, with a fixed interest rate and a set repayment schedule over a specified term.
This may be a good option if you are going to renovate your home or make a large purchase because they provide predictable monthly payments making budgeting easier.
HELOC loans are a line of credit allowing homeowners to borrow as needed. However, these have variable interest rates, making repayment less predictable.
NOTE
Ensure you read all the terms & conditions to know the true amount you are borrowing and will need to repay.
If you need funds over a long period, like for higher education, HELOC may be a good option for you. They have more flexibility & fund access, but the variable interest rate poses a risk.
Before agreeing to one, you should consider all the pros & cons of a loan. These second mortgages provide lower interest rates than others but come with risks stemming from collateralization.
Home Equity Loan FAQs
They are loans made based on the equity you have in your home.
You can use the funds from this loan for many different reasons, like home improvement, education, debt consolidation, & other major expenses that have a high up-front cost.
Most lenders allow you to borrow up to 80% of your home's equity. However, this limit can change depending on your income, credit score & debt-to-income ratio.
You make fixed payments over the span of your loan product terms, whether that is 5 years or 30 years. You can refinance anytime if you find another loan product with better terms or rates.
Since the house is collateral for the loan, you may be forced to foreclose by your lender. Therefore, you should evaluate your repayment ability before taking this loan.
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