What is a home equity loan?
Home equity loans — also called second mortgages and equity loans — allow homeowners to borrow money against the equity in their homes. They hold a fixed interest rate and can have a repayment term of one to thirty years. Home equity loans can offer a competitive rate compared to other consumer loans. However, other home equity loan alternatives may offer the best rate depending on the market.
How do home equity loans work?
At a glance, a home equity loan works similarly to most other loans — a borrower takes a lump sum of money and repays it in fixed installments over a set period. Lenders will set the fixed interest rate, loan amount, and repayment terms — and the borrower chooses to agree.
The amount you can borrow 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 take up to 85% of their home's worth. For example, a house worth $500,000 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 (DTI).
Unlike other loans, home equity loans often have associated closing costs. The costs vary based on the lender but commonly range from 2% to 5%. Again, depending on the lender, you can potentially roll closing costs into your monthly payments.
The pros and cons of home equity loans
In addition to confidently answering “how do home equity loans work,” it's essential to understand the advantages, disadvantages, and true cost of borrowing.
Pros
- Lower rates: They offer competitive rates compared to other alternatives — interest rates range from 2.5% to 9.99%, depending on the length of your repayment terms.
- Fixed interest rate: There's a set interest rate over the life of the loan — this exempts borrowers from the volatile housing market.
- No restriction on funds: You have access to the total amount of the loan immediately and are free to use the funds however you choose.
- Long repayment terms: The repayment term can be as long as 30 years.
Cons
- Monthly payments: Taking on additional expenses can greatly reduce your monthly cash flow.
- Closing costs: Unlike other consumer loans, you'll be charged 2% to 5% in closing fees.
- Owing more than it's worth: Home equity loans are determined based on the value of your home during the market conditions in which you apply. Consequently, if your property value drops significantly, you could owe more than your home is worth.
- Foreclosure risk: If you fall behind on payments, you may need to sell your home to repay the loan. In severe cases, you could lose your home.
What are the requirements for securing a home equity loan?
The requirements for a home equity loan vary from lender to lender. However, there are specific criteria that every lender will assess:
- Equity: To qualify, you should own at least 16% of the equity in your home — holding more will allow you to secure more funding.
- Credit check: A minimum credit score of 680 is favorable for most lenders. Similar to other loans, a higher score will give you a better rate.
- DTI: A debt-to-income ratio of 43% is necessary to qualify for a home equity loan. DTI is calculated by dividing your total monthly bill payments by your gross monthly income.
