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. They work similarly to most types of loans — a borrower takes a lump sum of money and repays it in fixed installments over a set period. 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 (DTI).
Home equity loans can offer a competitive rate compared to other consumer debt products, like personal loans and credit cards. However, unlike other loans, they often have associated closing costs. The costs vary based on the lender but commonly range from 2% to 5% of the loan amount.
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 be required to provide 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%.
- Loan-to-value (LTV) ratio: The loan-to-value ratio is the ratio of the home equity loan amount to the appraised value of your home. Lenders often set a maximum LTV ratio of 80% — meaning you can borrow up to 80% of your home's appraised value.
- Proof of homeowners insurance: Most lenders require you to have 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 how you can leverage your home equity loan funds. You can finance various goals, such as:
- Eliminating or consolidating debt
- Renovating your home
- Buying a second home
- Covering medical expenses
- Boosting your retirement savings
- Making aging-in-place home upgrades
- Funding an investment or business venture
- Paying for IVF or adoption
- Covering other major purchases or recurring bills
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 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.
- Long repayment terms: The repayment term can be as long as 30 years.
- Tax deductions: In some cases, the interest paid on a home equity loan may be tax-deductible, especially if the funds are used for home improvements.
Cons:
- Monthly payments: Taking on additional expenses can significantly 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 property.
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, it 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. It's likely your application may require a cosigner. Working with a strong cosigner can improve your chances of qualifying.
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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, you can experience changes in your monthly repayments.
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. You'll get new mortgage terms and new rate when you refinance. Therefore, this option makes sense if you can secure a lower rate than your current one.
Currently, rates are at an all-time high, making this a rather expensive product. The average rate for a 30-year fixed refinance is 8.07%, and the average for a 15-year fixed-rate refinance is 7.19%.
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.
Is a home equity loan a good idea?
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.
