What Is a Home Equity Loan?

Looking to secure some extra funds? If you own a home, you could qualify for a home equity loan to gain access to quick cash. A home equity loan allows homeowners to secure money by borrowing against their home’s value, using the built-up equity as collateral. If you think a home equity loan might be right for you, make sure to take a careful look at what it involves before taking the plunge.

Owning a home comes with many advantages, and a home equity loan stands out as one of them. After you build up enough equity on your home, you can borrow against that equity. Then homeowners can use the money however they want, whether you want to pay for some home renovations, fund college tuition, or eliminate credit card debt.

But how exactly does a home equity loan work and do you qualify? Continue reading to find out all you need to know to get started.

Types of Home Equity Products

Homeowners have two options when taking out a home equity loan: a home equity loan and a home equity line of credit (HELOC).

Home Equity Loan

A home equity loan allows the borrower to take a lump sum of money and repay the loan in fixed monthly payments. The interest rate stays the same throughout the duration of the loan. Each month, the borrower pays a fixed rate that reduces the balance and pays off the interest. This type of home equity loan makes sense if you need a large, one-time loan to cover expenses. Loan terms are laid out upfront, making monthly repayments predictable and easy to budget.

Home Equity Loan Benefits:

• Predictable payments
• Ideal for large lump sum of cash

Home Equity Line of Credit (HELOC)

HELOC mortgage lenders give homeowners the option of a home equity line of credit, or HELOC. After approval, you can borrow money multiple times through a revolving line of credit, similar to a credit card. You can pay off the money incrementally in smaller payments or all at once.

With a home equity line of credit, you have the flexibility to control the loan balance and variable interest costs. You only have to pay line of credit interest rates on the money you actually borrow. HELOC credit score requirements vary by lender, but generally, a minimum score of 620 is required.

HELOC Benefits:

• Revolving access to credit
• Flexible withdrawals
• Only pay interest on the amount borrowed

Cash-Out Refinance

Homeowners can refinance to cash out some of the equity on the property and negotiate the terms of the current mortgage. With mortgage refinancing, the borrower replaces their existing mortgage with a new loan. The borrower increases the total mortgage loan and takes out the difference in cash, which they can use for expenses.

Cash-Out Refinance Benefits:

• Lower interest rates
• Better for borrowing larger amounts of money
• Could improve mortgage terms

HELOC vs. Home Equity Loan

Not sure whether a HELOC or home equity loan makes sense for your situation? In both cases, you’ll borrow against the value of your home to take out a second mortgage. However, some key differences will help determine the better option for you. Let’s compare the pros and cons of each, so you can choose the right equity loan product based on your needs.

How to Qualify for a Home Equity Loan

Every lender has different requirements, and some may have more flexibility than others. To get the best rates and terms on a home equity loan, lenders consider the following factors:

Loan-to-Value (LTV) Ratio: The loan-to-value ratio helps lenders assess the risk of providing a home equity loan. It measures the difference between your mortgage balance and the value of your home. Lenders will perform an appraisal to check your current home value.

Lenders often require an LTV ratio below 80% for primary residences, but may lower it to 70% for rental properties. A higher LTV indicates higher risk, in which case lenders may increase interest on the loan. Reducing the LTV ratio can help you get better rates and terms on your home equity loan, saving you money.

Credit score: Credit score and credit history come into play. The higher your score, the better your chances of getting approved for a home equity loan. Having strong credit also helps to qualify for a lower interest rate. Generally, lenders look for a credit score of 620 or higher. Good credit over 700 will secure even better rates on your home equity loan.

Debt-to-income ratio: Your debt-to-income ratio helps lenders determine whether or not you can afford additional monthly payments from a home equity loan. Typically, lenders prefer that total monthly debts, including mortgage payments and home equity payments, equal no more than 43% of your gross monthly income.

Collateral Requirements: Most lenders require the home equity loan to be taken out on the owner-occupied, primary residence. Some allow rental or investment properties as collateral. However, loans with home as collateral on secondary residences often have stricter requirements.

What Can a Home Equity Loan Be Used For?

Home equity loans provide homeowners with an excellent source of funding. This type of loan allows borrowers to use the money however they want. The flexibility of home equity loans means you could pay for a wedding, go on vacation, or as home improvement loans to finally complete those kitchen renovations. Others may use cash from a home equity loan for more practical reasons, like covering medical bills or paying off high-interest debt. The choice is yours!

Common Reasons for Home Equity Loans

• Home Improvement: Funding renovations or home repairs with a home remodel loan
• Debt Consolidation: Using home equity to consolidate and pay off high-interest debt
• Large Expenses: Medical bills, college tuition, or other significant expenses

The Benefits of a Home Equity Loan

Flexibility: Borrowers who acquire a home equity loan can use that money for whatever they need. Lenders don’t restrict the loan to paying for home-related expenses.

Low interest rates: Home equity loans typically have lower monthly interest rates, especially compared to other loan types.

Secures a large sum of money: Home equity loans can help qualify for relatively large loans. With this money, borrowers can pay for a host of things like a wedding, higher education, home improvements, or starting a business.

The Disadvantages of a Home Equity Loan

It puts your home at risk: By putting your house up as equity, it means that if you fail to make your payments, the bank can foreclose your home, seize the property, and sell it.

Taking out another loan could pile up debt: If you have other types of debt, such as credit card debt, taking out another loan could lead to accumulating debt that you can’t afford.

Home Equity Loan vs. Other Loan Products

Different loan products come with their own advantages. It makes sense to understand the terms of each, so you can decide on the right loan for your needs.

Home Equity Loan vs Cash-Out Refinance: A cash-out refinance replaces your current mortgage with a larger loan. Homeowners can use the cash that exceeds the home value on expenses. Cash-out refinance has lower rates than a home equity loan, but it comes with higher fees. This product makes sense for those looking to cash out larger loan amounts.

Home Equity Loan vs Personal Loans: A home equity loan requires taking out a 2nd mortgage and puts your home at risk of foreclosure if you can’t pay on time. Lenders offer personal loans as an option to secure quick cash without collateral. However, personal loans may come with higher interest rates than a home equity loan. Personal loan rates can range from 11% or 36% or higher, depending on the lender, market, and your financial standings. If you have good credit, you can qualify for a lower interest rate.

Costs and Fees for Home Equity Loans

Taking out a home equity loan does come with certain closing costs and fees. Typical closing costs for home equity loans and HELOCs range from 2%-6% of the loan amount. The fees associated with home equity loans can include appraisal fees, title insurance, and origination fees. They vary by lender. Origination fees could cost 0.5%-1% of the total loan, which would equal between $500 to $1,000 on a $100,000 loan.

Common Home Equity Costs and Fees

• Origination fees: 0.5% to 1% of the loan amount
• Appraisal fees: $300 to $450
• Credit report fee: $10 to $100
• Legal fees: Flat hourly rate or percentage of the loan amount
• Filing/notary fees: $20–$100
• Title insurance costs: 0.5%-1% of purchase price
• Title search fee: $100–$450

No-Closing-Cost Options: Despite the name, this type of loan option doesn’t not waive closing costs entirely. Instead, some lenders allow borrowers to roll closing costs into the loan, but this increases the total loan amount.

Costs vary from lender to lender. It makes sense to take the time to compare loan offers to get the right deal on your home equity loan.

How to Choose the Right Home Equity Lender

If you feel confident that a home equity loan is right for you, then you can easily apply online. Many home equity lenders allow homeowners to apply through their websites. These services compare home equity rates and terms so you can choose the most suitable option for your financial needs.

Tips for choosing your home equity lender:

• Assess Your Financial Needs: Consider factors such as how much you want to borrow, your credit score, and the purpose of taking out a loan. This can help eliminate certain options and guide you through the lending process.
• Compare Interest Rates and Fees: Look at different lenders and compare their rates and fees
• Consider Loan Types: Some lenders specialize in home equity loans, while others focus on HELOCs or offer both. Compare home equity loans and products from different lenders to find the right option that fits your priorities and budget.

How to Apply for a Home Equity Loan

If you have already applied for a primary mortgage then you’ll find the application and approval process of a home equity loan quite similar. You can start the application process online with a digital lender or in-person with a traditional lending service.

To speed up the process, it helps to have information regarding your current financial standings, your mortgage, and your home value. This can help receive a more accurate initial prequalification, so you get a rough estimate of the loan amount, terms, and interests you can expect from your home equity loan.

Once you have decided to move forward with the application, you’ll need to go through an official preapproval process. During this stage, the lender will request financial documents and run a hard credit check. They will send an underwriter to perform an appraisal on your home to find out its value. From there, you’ll get your offer, including all fees and costs.

Common documents needed for a home equity loan include:

• Identification
• Bank statements
• Tax returns
• Income verification
• Credit report
• Assets report
• Pay stubs