How to apply for a home equity loan: A guide

Over 80% of U.S. homeowners have mortgage interest rates below 6%, and the average homeowner has more than $300,000 of equity in their homes. With interest rates hovering around 7%, many people want to learn how to apply for a home equity loan so they can get cash from their homes without impacting their low fixed interest rate mortgage. 

Here's how a home equity loan works, how to apply, and four alternatives to consider when accessing the equity in your home.

How a home equity loan works

A home equity loan is a second mortgage that uses your home as collateral. The monthly payment works like mortgages or personal loans, where repayment is a combination of interest and principal. The loan term typically varies from 5 to 30 years, with fixed rates providing consistent monthly payments that homeowners can easily budget for.

The loan amount depends on the amount of equity in your home and the bank's maximum loan-to-value (LTV). Your home equity is calculated by subtracting your first mortgage balance and any debts tied to the property from the home's value.

For instance, let's say your home is worth $400,000, and you have a mortgage balance of $250,000; you would have $150,000 in equity. However, you cannot borrow the full $150,000. If the bank has a maximum LTV of 80%, the combined balance of your first mortgage and home equity loan cannot exceed $320,000. This means that you can apply for a home equity loan of up to $70,000.

Because your home secures the loan, it’s important to keep up with monthly payments. Falling behind could lead to late fees, credit damage, or—in a worst-case scenario—foreclosure. Be sure the payments fit comfortably within your budget before moving forward.

How to apply for a home equity loan

The specific steps to apply for a home equity loan vary by lender. However, most lenders follow the same general process when qualifying for a home equity loan.

Check your financial health

To get approved, your financial situation and credit score need to meet the lender's minimum requirements. Not only must you be able to make the minimum monthly payments, but your credit needs to be in good shape.

Start by making a list of your monthly debt payments, including your mortgage payment, auto loans, credit card minimum payments, personal loans, and student loans. Add up the minimum payments and compare that total against your monthly income. This is known as your debt-to-income(DTI) ratio. Typically, lenders want your DTI to be under 43%, including the payments for the home equity loan you're applying for.

Then, get a free copy of your credit report at AnnualCreditReport.com to understand your score and look for fraudulent accounts and errors. Lenders typically look for a score above 620. Additionally, you can identify accounts to focus your efforts on improving your credit score. Besides making all your monthly payments on time, the best way to improve your credit score quickly is by reducing the balances on your revolving credit (like credit cards or a home equity line of credit).

Gauge your home’s worth

Although most home equity loan lenders will require a formal home appraisal during the application process, having a solid estimate of your property’s value ahead of time can help you shop lenders more effectively and understand how much equity you may be able to access. It also gives you a baseline to evaluate any appraisal results.

Online tools from sites like Zillow, Redfin, or Point offer free and quick home estimates to guide your conversations with lenders. While it may be tempting to order a full appraisal for precision, it can be costly—and many lenders only accept appraisals ordered through their own process, potentially requiring you to pay for one twice.

Gather your necessary documents

Lenders request multiple documents when qualifying for a home equity loan. When thinking about applying for a home equity loan, assembling these documents ahead of time is one of the smartest steps you can take. By providing all of the documents quickly, you can speed up the application process tremendously.

Here is a sample of the types of documents and information that lenders usually request:

• Personal information (date of birth, Social Security Number, valid ID)
• Current mortgage statement
• Property tax statement
• Homeowner's insurance policy and agent contact information
• Current employment information (including contact info for employment verification)
• Recent paycheck stubs
• Last two years of tax returns and W-2s
• Last two banking and investment statements

Shop around and prequalify where you can

Whether you're buying a car, purchasing an appliance, or applying for a loan, shopping around helps you find the best deal. When qualifying for a home equity loan, it's also a good idea to explore offers from multiple lenders. Getting multiple quotes can help you uncover higher LTV maximums and lower interest rates. You may also be able to avoid common mortgage fees, like appraisals and origination fees, or even save on closing costs. 

When shopping around, most lenders will request your permission to check your credit score. Unfortunately, multiple inquiries can lower your score if you're not careful. One way to avoid unnecessary credit inquiries is by prequalifying for a home equity loan. Prequalification does a soft credit pull, which does not impact your credit score.

Apply for the loan of your choosing

After researching loan options, compare the pros and cons of each offer to find the one that best meets your needs. Depending on which lender you select, you may be able to apply online, in person, or over the phone. Some people prefer the convenience of applying online, while others want to speak with someone who can answer questions and provide guidance along the way.

If you apply for a home equity loan with a bank where you have an existing relationship, they may be able to provide a speedier application process.

Undergo underwriting

The underwriting process for a home equity loan is similar to getting a mortgage. Lenders will order an appraisal of your home. These in-depth reports identify a home's features, upgrades, and condition to determine the value of a home. 

There are three types of appraisals – full inspection, "drive by," and desktop. A full inspection is the most accurate and time-consuming, while a drive-by focuses on the exterior of the home. Desktop appraisals are done remotely. Appraisals typically cost $300 to $450 or more, depending on the type of appraisal and the size and location of the property. 

After identifying your home's value, the current mortgage balance is subtracted to determine the amount of equity in your home.

At the same time, underwriters are reviewing your monthly income and credit report to determine your ability to make monthly payments on the loan. During this process, the lenders will verify your employment and sources of income.

In some cases, the underwriters may need additional paperwork from you or answers to questions. It is important to respond quickly to keep the underwriting process moving forward. In general, you should respond within 24 hours of receiving a request.

Once the underwriters have thoroughly evaluated your financial situation and loan request, they'll make a decision to approve or deny your application.

Receive your funds

With a home equity loan, you'll receive a lump sum of money upon approval. From application to receiving funds, you can expect this process to take an average of two to six weeks.

After you've been approved, lenders usually deposit the money directly into your bank account. However, if you're doing a debt consolidation, you may be able to request the lender to pay off specific accounts directly.

If you have a bank account with your chosen lender, the funds are typically deposited the same day. For borrowers with accounts at another bank, the money is typically wired to be received within one to three business days.

Home equity loan alternatives

A home equity loan is a good option for many homeowners, but it isn't the best choice for every financial situation. Here are four home equity loan alternatives to consider before submitting your application.

• Home equity line of credit (HELOC): A HELOC is another type of second mortgage that leverages your home's equity. Instead of receiving a lump sum of money, you have a credit limit that you can use repeatedly during your draw period (typically 10 years). As you repay your balance, you'll free up additional credit to use at a later date. HELOCs have a variable interest rate, with interest-only monthly payments during the draw period based on how much you borrow.
• Home equity investment (HEI): Homeowners who want to tap their home equity without incurring another monthly payment should consider a home equity investment (HEI). With an HEI, homeowners get cash upfront in exchange for a share of their home’s future appreciation. The investment can be repaid anytime during a flexible 30-year term, when the homeowner sells, refinances, or uses another source of funds. This financing option is also a smart choice for homeowners who lack traditional income or have less-than-perfect credit.
• Refinance: A cash-out refinance allows homeowners to pull cash out of their home by replacing their current mortgage with a larger one. This is a good option for homeowners whose interest rate is similar to current rates or who want to eliminate mortgage insurance premiums on an FHA loan. However, unless you select a shorter loan term, you're resetting the 30-year payoff clock, which extends your mortgage payoff date and can lead to paying higher amounts of interest.
• Reverse mortgage: Seniors who qualify can apply for a reverse mortgage. These mortgage loans have three options: a lump sum of cash, monthly income checks, or a line of credit. Like an HEI, reverse mortgages do not have monthly minimum payments, but borrowers are still responsible for property taxes, insurance, and upkeep. However, these loans come due if the borrower passes away or moves out of the home for an extended period, including moving into hospice or long-term care. This can impact spouses, children, and others who live in the house with the borrower, but aren't on the loan. It’s critical to weigh the pros and cons before applying for a reverse mortgage. 

Final thoughts

Home values are near historic highs, which means that many borrowers have equity in their homes. But, more than 80% of homeowners have a below-market interest rate on their primary mortgage. In order to tap their home equity, many borrowers want to learn how to apply for a home equity loan. 

These steps include determining their home equity, how to find and compare lenders, and how to prepare their finances and credit score before applying. It is also helpful to consider alternative financing options to find the best fit for their borrowing needs.

Ready to tap into your home equity with no monthly payments? Explore Point’s Home Equity Investment (HEI). 

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