Unlocking equity: How do home equity loans work?

Unlock the potential of your home's equity with our comprehensive guide on home equity loans. Learn how to leverage this asset wisely and explore home equity loan alternatives.

Siarra Ortiz
January 10, 2024

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Do you know how much equity you have in your home? An advantage to being a homeowner is harnessing the equity you've built up when you need cash. With rates more competitive than other debt products, home equity loans are an attractive solution for most homeowners.

If you've been mulling over whether a home equity loan is a good idea, this comprehensive guide will help you determine if it's right for you. Explore the pros and cons and discover home equity loan alternatives in this insightful post.

How does a home equity loan work?

Home equity loans, or second mortgages, allow homeowners to borrow against the equity in their homes. A borrower takes a lump sum of money and repays it in fixed installments over a set period, typically 5-30 years. Lenders set the fixed interest rate, loan amount, and repayment terms — and the borrower agrees.

The loan amount will vary based on how much of your home's equity you own — which is determined by the current market value and the remaining balance of your mortgage. Generally, borrowers can access up to 85% of their home's worth.

For example, if you owned your house outright and it's worth $500,000, you would be eligible for a maximum loan of $425,000. However, there might be additional restrictions on how much you can borrow based on a credit check and your debt-to-income ratio.

It typically takes two to four weeks to get funded.

What are the requirements for a home equity loan?

The requirements can vary depending on the lender and your individual financial situation. However, when applying for a home equity loan, lenders will look for:

  • Sufficient equity: Lenders typically require that you own at least 20% to 25% equity in your home.
  • Good credit score: In most cases, the minimum credit score requirement is 620, but 680 is favorable among lenders.
  • Stable income: You'll need proof of employment or income, such as pay stubs, W-2 forms, or tax returns.
  • Debt-to-income ratio (DTI): DTI is the percentage of your income that goes toward debt payments. Requirements vary from lender to lender, but most have a maximum threshold of around 43%.
  • Combined loan-to-value (CLTV) ratio: The CLTV ratio is the ratio of secured debt on the property to the appraised value. Lenders often set a maximum CLTV ratio of 80%.
  • Proof of homeowners insurance: Most lenders require sufficient homeowners insurance covering the property.
  • Homeownership: The home must be yours and, in most cases, your primary residence. Some lenders offer home equity loans for second homes or investment properties, but the requirements can be stricter.

What can you use a home equity loan for?

There are no restrictions on leveraging your home equity loan funds. You can finance various goals, such as:

The pros and cons of home equity loans

When deciding if a home equity loan is a good idea, weighing the benefits and risks is essential.

Pros

Lower interest rates

Home equity loans have lower rates than other debt products, like personal loans. Depending on the length of your repayment terms, interest rates range from 2.5% to 9.99%.

Fixed rate

There's a set interest rate over the life of the loan. This exempts borrowers from the volatile housing market and ensures fixed monthly payments.

Flexible loan terms

Repayment can vary from 5 to 30 years, empowering you with financial flexibility. You can explore lenders to ensure the repayment window balances your short and long-term financial plans.

Tax deductions

Sometimes, the interest paid on a home equity loan may be tax-deductible, mainly if the funds are used for home improvements.

Cons

Monthly payments

Repayment on the loan begins almost immediately. You'll be accountable for monthly payments over the repayment term you agree to, which can significantly reduce your cash flow.

Fees

You'll be responsible for various expenses, such as application fees, appraisal fees, and closing costs.

Underwater mortgage

If your home value drops, leaving you to owe more on your mortgage than your home is worth, you'll be considered 'underwater.' Being underwater makes selling or refinancing your home challenging unless you can cover the difference out of pocket.

Foreclosure risk

Since your property is used as collateral, if you stop making payments, you could lose your home.

equity-financing

Can you get a home equity loan with bad credit?

Obtaining a home equity loan with bad credit isn't impossible—it's just more difficult. Although qualifying for the loan typically requires a 680 credit score, some lenders will work with a score as low as 620. Unfortunately, this can result in a higher interest rate.

If you're applying with a lower credit score, share as much financial information as possible, such as income, assets, and investments. Your application may likely require a cosigner, and working with a strong cosigner can improve your chances of qualifying.

How to get a home equity loan

Evaluate your situation

The first step is to review your home equity and financial health to gauge your eligibility. If you're on the border of qualifying, it may be best to improve your situation before applying or consider an alternative option.

Compare lenders

Shop around and compare offers from multiple lenders, including banks, credit unions, and online lenders. Look for lenders that offer competitive interest rates, favorable terms, and have good customer reviews.

Gather your documents: Being prepared is the easiest way to streamline the application process. You'll typically need proof of income, such as pay stubs or tax returns, as well as documentation related to your home, such as property tax assessments and insurance information.

Submit your application: Be prepared to provide detailed information about your income, assets, debts, and the purpose of the loan. The lender will also appraise your home to determine its current value and verify the amount of equity you have.

Complete the closing process: Once you've chosen a loan offer, you'll need to complete the closing process. This typically involves signing the necessary paperwork and paying any closing costs or fees associated with the loan. After closing, your home equity loan funds will be disbursed, and you can use them as needed.

Home equity loan alternatives

Whether you're worried about qualifying or prefer better terms, there are various home equity loan alternatives that may be a better fit.

Home equity line of credit (HELOC)

A HELOC allows you to tap into your equity for a revolving line of credit. It works similarly to a credit card but offers a more competitive interest rate. You can borrow funds up to a set limit during the draw period, typically ten years.

After the draw period, the balance due is converted into a principal-plus-interest loan, and the repayment period begins. The repayment period can last up to 20 years.

HELOCs have variable interest rates that change with market conditions. As a result, your monthly repayments may change.

Best for: Borrowers who want flexible access to funds and are prepared to cover varying monthly payments.

Cash-out refinance

A cash-out refinance replaces your primary mortgage with a larger one and lets you pocket the difference in cash. Unlike a home equity loan, you'll have only one monthly payment—a larger mortgage payment.

When you refinance, you'll get new mortgage terms and a new rate. Therefore, this option makes sense if you can secure a lower rate than your current one.

Best for: Borrowers who want cash and to change their mortgage terms.

Home Equity Investment (HEI)

Another competitive home equity loan alternative is a Home Equity Investment (HEI). With an HEI, you get access to a lump sum of cash in exchange for a share of your home's future appreciation. There are no monthly payments. Instead, you repay anytime during a 30-year term when you decide to sell or refinance.

HEI requirements are more flexible than other equity products. You'll need a minimum credit score of 500, and there are no income requirements.

Best for: Borrowers who have trouble qualifying for other products or want to do away with monthly payments.

Reverse mortgage

Homeowners aged 62 or older can leverage a reverse mortgage for cash. Unlike traditional mortgages, where homeowners make monthly payments to the lender, with a reverse mortgage, the lender makes payments to the homeowner.

Reverse mortgages pay out as a lump sum, a line of credit, or regular fixed payments. The main advantage is that the borrower typically doesn't need to repay the loan so long as they continue to live in the home as their primary residence, maintain it, and pay property taxes and insurance. Instead, the loan is paid when the homeowner sells the home, moves out permanently, or passes away.  

Is a home equity loan a good idea?

Whether or not a home equity loan is a good idea depends on your situation. A home equity loan may be worth it if you:

  • Have good credit, stable income, and sufficient equity
  • Want to borrow a lump sum at a reasonable, fixed interest rate
  • Want a long repayment term

The bottom line

Deciding if a home equity loan is right for you depends on your unique situation and goals. While the loan has many advantages, there are also various cons to consider. When mulling over whether or not to move forward, weigh the impact you'll see on your short and long-term finances.‍

If monthly payments or requirements don't suit your situation, explore home equity loan alternatives. A Home Equity Investment from Point can help you access cash without restricting your monthly cash flow. Visit Point.com to learn more.

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