Reader-friendly guide to home equity loans
Need cash? If you're a homeowner, you're probably aware that home equity loans are a popular option for borrowing money. But you may be uncertain about what they involve and how to navigate the potential benefits and risks.
This guide is designed to help you quickly and easily find out what you need to know about home equity loans. Each section provides a brief overview of a key aspect of home equity loans, with links to further reading at key points.
Read as much or as little as you wish – the guide lets you take things at your own pace.
Why a home equity loan?
So why do people opt for home equity loans when they need to borrow money? There are three key reasons:
• Home equity loan rates are significantly lower than for unsecured debts, such as credit cards and personal loans.
• There can be tax advantages, as interest on home equity loans is usually tax deductable.
• Closing costs on home equity loans are relatively low and in some cases, nonexistent
What is a home equity loan?
A home equity loan is when you borrow money using the equity in your home as collateral. That is, you use the portion of your home that's paid for to back the loan.
Let's say you've got a $300,000 home and you still owe $100,000 on your mortgage. That means you've got $200,000 in home equity, and could borrow against a portion of that through a home equity loan.
Because a home equity loan is secured by the value of your home, you could lose the property to foreclosure, the same as if you fail to make the payments on your regular mortgage.
Home equity loans are available through most mortgage lenders. You can apply through the lender that gave you your primary mortgage, but it isn't required – in fact, shopping around for the best home equity loan rates and terms is strongly encouraged.
To qualify for a home equity loan, you need three things: home equity, credit and income. These all affect each other, so being stronger in one area can offset being weaker in another. For example, a strong credit score may help you qualify despite having limited equity, or vice versa.
You need enough sufficient home equity to both borrow against and leave an adequate cushion afterwards. In practical terms, that means you need to have at least 25-30 percent equity in your home in order to qualify for a home equity loan (see "How much can I borrow," below) in order to both cover the amount of the loan and leave 15-20 percent equity remaining.
A credit score in the mid-600s is usually adequate to qualify for a home equity loan, unless you're borderline on income or equity. A score in the 700s is a safer bet, though it's possible to qualify with a score as low as 620 if other guidelines are met.
On income, what actually matters is your debt-to-income ratio, or the amount of your monthly income required to cover your debt payments, including your mortgage and the new home equity loan. The rule of thumb is that your total monthly debt obligations shouldn't exceed 45 percent of your gross monthly income.
Understanding the different types
Home equity loans come in two types: the standard home equity loan and the home equity line of credit, or HELOC.
With a standard home equity loan, you borrow a certain amount of money and repay it over a specified period of time.
A home equity line of credit, on the other hand, allows you to borrow up to a certain limit as you see fit, in whatever amounts and at whatever times you wish. It's like a credit card, only one that allows you to borrow money instead of charging purchases to it.
A regular home equity loan is useful if you need a lump sum of cash for a particular purpose, such as paying off other, high-interest debts or a one-shot home improvement such as replacing your roof. They're usually set up as fixed-rate home equity loans, so your monthly payments never change and you begin repaying it almost immediately. Loan terms usually run from 5-15 years.
A HELOC is good for an ongoing project where you'll have irregular expenses over time, such starting a business or a home improvement project where you'll be paying for supplies and the work in stages.
HELOCs are divided into a draw period, typically 5-10 years, when you can borrow against your line of credit, and a repayment period when you pay back whatever you've borrowed. They're usually set up as an adjustable-rate, interest-only loan during the draw period, then convert to a fixed-rate home equity loan when the repayment period begins.
HELOCs generally offer the best home equity loan rates, at least initially, because adjustable rates run lower than fixed ones do. However, that can change over time if market rates increase and your HELOC rate rises with them.
With many HELOCs, you can repay loan principle without penalty during the draw period, then borrow again as needed, so it can serve as a reserve pool of funds to use and repay as the situation warrants.
HELOCs tend to have lower up-front fees than standard home equity loans, and may charge no origination fee at all. However, you may have to pay an annual fee for each year the line of credit stays open, regardless of whether you have an outstanding balance or not.
More information: Home Equity Loan vs. HELOC: Know the Differences
Most home equity lenders will allow you to borrow up to 80 percent of the available home equity in your property. To determine what you can borrow, take the current value of your home and subtract what you still owe on your primary mortgage and any second liens you may have (other home equity loans, a piggyback loan used for a down payment, etc). Take that figure and multiple by 0.8, or 80 percent. The answer is the amount of home equity you can borrow against.
For example, suppose your home is worth $250,000 and you still owe $150,000 on your mortgage and have no other second liens. Your calculations would be:
$250,000 - $150,000 = $100,000 in home equity
$100,000 x 0.8 (80 percent) = $80,000 available to borrow against
So in this example, you could borrow up to $80,000.
Some lenders will allow you to go above the 80 percent figure, to 90 percent or more, but the home equity loan rates in such cases are significantly higher than for those that preserve at least 20 percent equity.
What's the difference between a home equity loan and a second mortgage?
A home equity loan is a type of second mortgage. That is, it's a secondary lien secured by the equity in your home.
The mortgage used to buy the home is your primary lien, of first obligation. In the event of a default, your primary lien gets paid in full before any second mortgages are paid. In other words, the second mortgage is "subordinate" to the primary lien.
For this reason, there is more risk for lenders and interest rates on second mortgages are higher than those for primary mortgages as a result.
Other types of second mortgages include piggyback loans, which are used to cover part or all of a down payment, and reverse mortgages, a type of loan available to seniors.
In common use, "second mortgage" is often used to refer to a home equity loan, although the term covers other types of subordinate home loans as well.
Home equity loans offer a number of advantages compared to other types of borrowing.
•Home equity loan rates are lower than you'll find on most types of consumer debt.
• You can use the money any way you like – you don't have to show your lender how you plan to spend the funds.
• Interest on home equity loans is usually tax-deductible. However, there are greater restrictions compared to what you can deduct on your primary mortgage. See the tax section below.
• Because lenders are primarily interested in how much home equity you have, getting a home equity loan when you have flawed credit can be easier than obtaining other types of consumer loans.
• Home equity loans can be repaid over as long as 15-30 years, far longer than many other types of consumer loans.
• HELOCs are one of the few ways you can still get an interest-only home loan. They're usually set up so you're only responsible for interest payments during the draw period, and don't have to begin repaying loan principle until the draw period ends.
More information: Home equity loan pros and cons
While there's a lot to like about home equity loans, there are some disadvantages to keep in mind as well.
• Because it's a second mortgage, if you don't keep up your payments you could lose your home to foreclosure.
• HELOCs have adjustable rates, meaning you could end up having to repay the principle at a much higher rate than you expected.
• You may have to borrow more than you want. Many lenders won't approve a home equity loan or HELOC for less than $15,000-$25,000, though some will go as low as $5,000-$10,000.
• Because they're a convenient source of money, home equity loans can make it easy to overspend. That's particularly true if your loan or line of credit gives you access to more cash that you originally planned on using.
• In some cases, you may be better off with a cash-out refinance than a home equity loan, particularly if you can reduce your overall mortgage rate by refinancing.
More information: Don't get trapped: Home equity loan pitfalls
Getting the best home equity loan
Shopping for a home equity loan is like shopping for any other item – you need to check out a variety of sellers to see who's offering the best home equity loans.
Start with the bank where you have your primary mortgage or other banking relationship, because many banks give discounts to established customers. Others may extend a discount to you if you open a checking or savings account at the time of your home equity loan application.
Online lenders make it easy to quickly compare terms and interest rates for home loans from a variety of institutions and quickly identify the best home equity loan rates. You can even handle the entire application and approval online.
Don’t neglect checking with your local credit union. They may waive costs for members, and some offer slightly lower rates than traditional banks.
Check out the home equity loan rates but also keep an eye on fees as well – high fees can often outweigh a low rate. With HELOCs, be mindful of how much your rate can adjust over time – you want to be protected if home equity rates soar abruptly.
More information: Shopping for a Home Equity Loan: 6 Steps for Success
Because home equity loans are a type of home mortgage, the interest paid on them is generally tax deductible. However, the rules aren't exactly the same as those for a primary mortgage.
If you itemize deductions on your income tax return, you're allowed to deduct the interest paid on up to $100,000 in home equity loan debt if you're filing as a couple, or up to $50,000 for single filers.
That's the basic rule. However, higher limits apply if you use the funds to repair or improve your home. In that case, it's considered home acquisition debt, the same as the mortgage used to originally buy or build your home.
The IRS allows couples to deduct the interest paid on up to $1 million in home acquisition debt, single filers up to $500,000. So if you use your home equity loan for home improvements, it counts toward those higher limits.
Combined, that means a couple can deduct the interest paid on up to $1.1 million of home acquisition and home equity debt, or a combined maximum of $550,000 for single filers.
You're allowed to deduct home equity loan interest on up to two homes owned for your personal use, such as your primary residence and a vacation home. In that case, the maximums would apply to the combined debt on both properties.
More information: Tax rules for home equity loans
What if you default on a home equity loan?
Just like your primary mortgage, a home equity loan is secured by the value of your home. And just like with a primary mortgage, you could end up losing your home if you default on your home equity loan payments.
A home equity loan is a second lien, which means in the event of default the lender doesn't collect until after the holder of the primary mortgage/first lien is repaid in full. But don't assume this means you're protected as long as you remain current on your primary mortgage payments. If you default on your home equity loan, the second lien holder can foreclose on its own, pay off the primary mortgage with the proceeds from selling the home and use what's left to pay itself.
Because the sums involved are smaller and the costs of foreclosure are proportionately greater compared to the sums that can be recovered, lenders tend to be more reluctant to foreclose on a home equity loan than on a primary mortgage. But that may only buy you a little extra time or leverage to work out a repayment plan if you fall behind – don't assume it will protect you forever.
Lenders aren't Santa Claus; but if you have bad credit, getting approved for a home equity loan can seem like a gift from the North Pole.
In today's market, it's much easier for people with flawed credit to get a home equity loan than it was a few years ago. Many lenders will approve borrowers with FICO credit scores as low as 620 or even lower, provided that they have sufficient home equity available and an acceptable debt-to-income ratio.
Bad credit home equity loans do come with a price, however. You'll find home equity loan interest rates and often the fees as well are higher than those charged to borrowers with good credit, sometimes substantially so. So you may have to ask yourself if you need the money badly enough to justify those higher rates.
Bad credit isn't forever, though. If you can wait that long, you might find it a better strategy to delay seeking the loan until your credit improves and you can qualify more easily and with a lower home equity loan rate. Maintaining a good credit record for just a couple years can make a significant difference in your credit score.
More information: Getting a Mortgage with Bad Credit
We've covered a lot of information here, and there's even more if you've followed the links for further reading. So it's ok if you feel a bit overwhelmed. But if you think a home equity loan is the right choice for you, you can simplify the process by just focusing on the following tips:
Shop around. Competition is a good thing for the consumer, and when it comes to home equity loans, there's plenty to choose from. More competition means lower home equity rates and cheaper prices. Research lenders on the Internet and get quotes on rates and closing costs.
Understand the loan. It's important to understand the specifics of your home equity loan or HELOC, and how loans differ. For example, the adjustable rate you initally get on a HELOC be lower than what you can get on a standard fixed-rate home equity loan, but may adjust substantially upward over the life of the loan. A standard home equity loan may offer fixed monthly payments, but your up-front costs will likely be higher than on a HELOC.
Scrutinize closing costs. Each mortgage lender is required, by law, to provide you with a Good Faith Estimate detailing these costs. Make sure that you understand all the charges, and keep a watchful eye out for bloated origination fees.
Get a loan you can afford. The days of predatory lenders writing home equity loans that borrowers couldn't afford came to a crashing end with the 2008 financial crisis, but that doesn't mean you can relax your guard. Just because you can get approved for a loan doesn't mean it won't strain your budget. You don't want your loan payments to force you to cut back on other budget priorities, like saving for retirement.
More information: Get Smart: Intelligent Ways to Use a Home Equity Loan
Home equity loans: Be on friendly terms
Used responsibly, home equity loans are among the best consumer financial tools on the market. Just do your homework, avoid the pitfalls listed above, and repay the loan on schedule. Do that, and you and your home equity loan will get along just fine – downright friendly, even.