Are you looking for ways to tap into your home equity? A home equity loan could be a viable option, as it lets you convert a portion of the home equity you’ve built up into cash. This guide explores the specifics of home equity loans, eligibility guidelines, the application process and how to decide if this loan product is right for you.
What is a Home Equity Loan?
A home equity loan is a type of installment loan that acts as a second mortgage. The amount you’re eligible to borrow is based on how much home equity you’ve built up or the portion of the home you own outright.
Most lenders cap your borrowing power at 85% of your home’s equity. So, if your home is valued at $425,000 and you owe $275,000 on the mortgage, you could potentially access up to $86,250 ($425,000 * .85 – $275,000) in funding.
Keep in mind that home equity loans aren’t without risk since your home is used as collateral. This means you could lose your home to foreclosure if you fall behind on the loan payments.
How Does a Home Equity Loan Differ from Other Loans?
For starters, home equity loans are secured and require collateral for approval. However, you can get a personal loan based on the strength of your credit history and income, as unsecured funding options are available.
It’s also possible to unlock more borrowing power with a home equity loan, particularly if you have a significant amount of equity in your home. Plus, home equity loans are less risky since they are secured, so lenders could be willing to extend more funding to you.
How Does a Home Equity Loan Work?
If approved, funds are disbursed in a lump sum and can be used however you see fit. You’ll get a fixed interest rate, so you’ll make equal monthly installment payments over a set period.
Understanding Equity: How it Builds Over Time
Your home equity grows over time as you make monthly mortgage payments or as your property value increases. Remember, more equity in your home could generally mean increased borrower power.
How Much Can You Borrow with a Home Equity Loan?
As previously mentioned, most lenders let you borrow up to 85% of your home’s equity. It’s the amount of your home you own outright or the current market value minus the outstanding mortgage balance.
Determining the Value of Your Home
The current market value of your home is determined by a licensed property appraiser. When you apply for a home equity loan, the lender will order a professional appraisal to assess your home and solidify this figure.
Calculating Available Equity
Again, the equity you have in your home is computed by subtracting what you owe on the mortgage from the market value. So, if your home is worth $400,000 and the mortgage balance is $300,000, you have $100,000 in equity.
LTV (Loan-to-Value) Ratio Considerations
The loan-to-value (LTV) ratio is also important to lenders. It compares the mortgage amount to the property value and should not exceed 85% to qualify for a home equity loan. Using the example above, an 85% LTV means you could borrow up to $340,000 minus what you owe on the mortgage.
How Do You Qualify for a Home Equity Loan?
Before applying for a home equity loan, you should familiarize yourself with the eligibility guidelines. They vary by lender, but here are some general requirements to be aware of.
Home Equity
Lenders typically want to see 15 to 20% in home equity before approving you for a home equity loan. To illustrate, if your home is valued at $375,000, your mortgage balance should not exceed $300,000.
Credit Score Requirements
A higher credit score gives you access to more competitive terms on a home equity loan. That said, lenders usually require a minimum credit score of just 620 to qualify, but you’ll likely receive less favorable rates and terms.
Income Requirements
Lenders want reassurance that you can afford to make timely payments on your home equity loan. So, they require you to provide proof of income, which could include recent pay stubs, tax returns and bank statements.
Debt-to-Income Ratio
Your debt-to-income (DTI) ratio also plays a role in your eligibility for a home equity loan. It’s the percentage of your gross monthly income used to cover debt obligations. Ideally, your DTI should be below 43% to have the best chance of getting approved for a home equity loan. That said, you could qualify if it’s higher and there are other compensating factors.
Steps to Apply for a Home Equity Loan
When you’re ready to move forward with the lending process, here’s what to expect.
Pre-Approval
Start by researching lenders and getting pre-approved with the one you select. The process involves submitting financial information for review. The lender will also conduct a credit check to determine if you potentially qualify for a home equity loan.
Documentation Needed
Prepare to provide income and employment information to substantiate the information you provided to the lender. In most cases, the lender may request recent pay stubs, tax returns and bank statements. You’ll also need to share information about your employer, along with recent mortgage statements and proof of homeowners insurance. Having these documents handy when you apply could help avoid delays in the processing of your application for funding.
Home Appraisal Process
If you’re pre-approved for a home equity loan, the next step is the home appraisal. The lender will order the appraisal to determine the current market value of your home. This figure, coupled with other financial factors, is used to determine how much you can borrow.
Loan Approval and Closing
Once the appraisal is complete and the underwriting team verifies your application information, the final step is closing. During this step, the lender will provide you with the loan agreement for review and signature. If there are any fees associated with the transaction, you’ll also need to pay them before the loan closes.
Loan proceeds are typically disbursed a few business days after closing. Upon receipt, you’re free to use them however you see, and you’ll begin making monthly installment payments per the loan agreement.
Home Equity Loans Interest Rates and Fees
As previously stated, home equity loans usually come with fixed interest rates. So, your monthly installment payments are easier to budget, and you’ll know your total borrowing costs when you enter into the loan agreement.
You can also expect to incur fees when taking out a home equity loan, including:
- Origination fees: the cost associated with processing the loan application
- Appraisal fees: the cost of the professional home appraisal
- Closing costs: the cost of title search, along with attorney fees and other related expenses
How Does Repayment of Home Equity Loans Work?
Here’s what to expect once the loan proceeds are disbursed.
Repayment Terms and Schedules
Home equity loans generally come with 5- to 30-year repayment periods. An extended loan term could mean more affordable monthly payments, but you’ll pay more in interest.
The monthly payments include both principal and interest. If the lender allows you to roll your closing costs into the loan, this amount will be reflected in the monthly payments as well.
Early Repayment and Prepayment Penalties
If you choose to repay the loan balance early, you could be penalized. Check with your lender to learn more about their prepayment policies.
What Happens If You Miss a Payment?
A late payment on a home equity loan isn’t the end of the world, as you’ll typically incur a late payment penalty once the grace period ends (if applicable). But missed payments are another story. Once the loan is 30 or more days late, the lender will likely report the delinquency to the credit bureaus, which could place a big dent in your credit score.
If the trend continues and you miss several payments, the lender could choose to initiate foreclosure proceedings with the courts. This means you could lose your home to foreclosure.
Conclusion: Is a Home Equity Loan Right for You?
There’s a lot to love about home equity loans, and they can benefit you financially if you have a plan for the funds. So, if you need money for a significant, one-time expense and can comfortably afford to make the loan payments, this option could be ideal. Otherwise, it’s best to consider alternatives to secure the funding you need.
Frequently Asked Questions (FAQs)
It’s possible to get a home equity loan with less-than-perfect credit, as some lenders have more lenient guidelines than others. Keep in mind that you likely won’t qualify for the most competitive financing terms.
The application process can take two to six weeks, depending on the lender. Being proactive about submitting requested documents and often communicating with the lender can help facilitate a seamless process.
It’s possible to have several home equity loans at once. However, this practice is not common, as most lenders want to be the first lienholder if you default on the loan agreement.
