One of the perks of purchasing a home is a special lending scenario known as a home equity loan, which becomes available to homeowners once enough money has been invested in the principle of a mortgage.
The key to effectively using an equity loan on a house is first understanding home equity loans. Throughout the following article, we’ll explain what they are, how to obtain them, and tips for effectively using your home’s equity.
How Does a Home Equity Loan Work?
A home equity loan unlocks a portion of your home’s equity, providing a lump sum payment for various uses. You’ll repay the loan with fixed monthly installments (principal and interest) over a set term, typically ranging from 5 to 30 years.
Obtaining a home equity loan hinges on your home’s equity, which grows as you pay down your mortgage and potentially through rising property values. Even recent homebuyers with lower down payments may qualify depending on their equity stake. For example, changes in the real estate market allowed most homeowners to collectively accrue an extra $1.3 trillion in home equity in 2023, which is up 8.6% from 2022.
Similar to a second mortgage, an equity loan on a home uses your home as collateral. This offers potentially lower interest rates than unsecured loans but also carries the risk of foreclosure if you default.
Much like when first purchasing a home, you’ll want to know your home buying power by determining your financing needs and calculating your home’s equity. This will allow you to shop around for lenders to find the most favorable home equity loan rates and terms. Once you have an idea of what your loan will look like, you’ll simply need to factor in the additional monthly payment to ensure it aligns with your budget.
Kinds of Home Equity Loans & How to Use Them
Like any lending situation, responsibly using the funds from an equity loan on a house is critical, as failure to repay can have similar consequences to defaulting on a mortgage.
As such, home equity loans should be used to increase the property’s value through repairs or renovations. However, the funds can typically be used however you see fit.
There are generally three different types of home loans available for financing a home:Â
- Fixed-rate home equity loans
- Home equity lines of credit (or HELOCs)
- Cash-out refinancingÂ
Each has similar criteria, though some kinds of loans (specifically, FHA loans) are limited in what’s available to the borrower.
The basic criteria for all home equity lending are as follows:
- A decent credit score of at least 620. Note that this will vary by lender, as many prefer to see a score of 680 or higher.
- Debt-to-income (DRI) ratios should be at or better than 43%. While income is important, lenders will be most concerned with how much is allocated toward all debts, similar to when you first apply for a mortgage.
- The loan-to-value (LTV) ratio should be 20% or higher. This is perhaps the most rigid requirement, as lenders will require at least this much equity to consider any type of home equity loan.
Fixed-Rate Home Equity Loans
A fixed-rate home equity loan is objectively the most straightforward method of borrowing based on your home’s equity.
Fixed-rate home equity loans provide a single lump sum payment at a fixed interest rate. You repay the loan with predictable monthly payments over a set term, typically 5-15 years. One important thing to consider is that the full loan amount is often due when you sell your home. If you plan to sell soon after taking an equity loan out on a house, you’ll need to ensure you’re not underwater for the sale.
Closing costs for fixed-rate home equity loans are similar to traditional mortgages. When comparing lenders, inquire about their closing costs and any additional third-party fees, as these can vary significantly.
This option is ideal for borrowers with a specific, one-time financing need. For instance, you might use a fixed-rate home equity loan to cover a $15,000 home improvement project and consolidate $10,000 in high-interest credit card debt, requiring a total loan of $25,000. Though it is best to spend funds on the property itself, taking advantage of an equity loan’s lower interest rates is still a responsible use of the loan (provided you don’t go back to accumulating more high-interest credit card debt!)
Cash-Out Refinancing
Refinancing is available to all mortgage types after a period of time and is typically the only option available to those with FHA loans.
Cash-out refinancing replaces your current mortgage with a new, potentially larger loan from an existing or different lender, allowing you to pocket the difference in cash. This can be used for various purposes, like home renovations or other expenses. It can also be used to transfer a similar or lower balance to a new loan with better terms, thus lowering monthly payments.
For example, a homeowner owes $150,000 on a $300,000 home and needs $15,000 to replace the roof. Through a cash-out refinance, they secure a new $165,000 mortgage and receive the $15,000 difference in cash, which will also likely result in a lower monthly mortgage payment.
Similar to fixed-rate equity loans, cash-out refinances incur closing costs, and at higher rates typical to most other home equity loans. However, unlike when you purchase a home with a real estate agent, you won’t need to pay commissions.
This approach might be ideal for those seeking a consolidated loan with potentially lower interest rates or a new loan term, especially if you’ve recently purchased a home, as interest rates are still quite high. For example, a homeowner with a 7-year-old mortgage at 6.5% interest will almost certainly benefit from refinancing once mortgage and home equity loan rates drop below 5%.
Home Equity Line of Credit (HELOC)
Last but not least is the home equity line of credit (HELOC) which works a bit differently than the home equity loans we just discussed.
A HELOC functions like a revolving credit line secured by your home equity, meaning it’s similar to a credit card that uses home equity to obtain financing. Unlike a fixed-sum home equity loan, you can borrow and repay funds over a draw period (often 10 years).
For example, with a $20,000 HELOC, you might borrow $15,000 initially, leaving $5,000 available. Repaying $10,000 would bring the amount you can access back up to $15,000.
Most HELOCs feature variable interest rates that adjust with market conditions, potentially increasing over time. This means that monthly payments may also fluctuate based on the borrowed amount and interest rate.
It’s vital to understand the two key HELOC phases:
- Draw Period. This refers to the initial 10-year term during which you can access funds from the line of credit, depending on the specific terms set by the lender.
- Repayment Period. Follows the draw period, with a set timeframe (often 20 years) to repay the borrowed amount in full. Payments during the draw period are usually interest-only, with principal repayment starting in the repayment period.
HELOCs are an ideal home equity loan for those who need ongoing access to funds for projects or expenses. They can be used for home renovations but can be applied to other expenses as the borrower sees fit. Just make sure to crunch the numbers and pay close attention to the terms and conditions, as the total cost for a HELOC can parallel that of some credit cards, but with harsher consequences should repayment falter.
Final Thoughts on Home Equity Loans
Borrowing an equity loan on a house can be an ideal way to negotiate financial hurdles while minimizing the impact incurred from other, higher-interest types of lending. Like all debts, make sure to fully understand the commitment and make sure to submit payments in a timely manner!
