What Is a Home Equity Loan?

Learn How Home Equity Loans Work

Home equity is the amount your home is worth minus your current mortgage balance. As a homeowner, you gain home equity if the value of your home increases over time and you continue to make mortgage payments. Once you reach a certain amount of equity, you may be able to tap into it with a home equity loan.

A home equity loan lets you borrow money against the value of your home's equity to pay for major expenses like home improvements and education costs. Many borrowers of home equity loans also use the funds to consolidate high-interest debt.

Freedom Mortgage doesn't currently offer home equity loans, but we will go over what they are, their benefits and drawbacks, how you can get one, and what your alternatives are.

How Does a Home Equity Loan Work?

Home equity loans are second mortgages that are similar to personal loans in that you can borrow a significant lump sum of money all at once and then repay it over a designated amount of time. However, unlike with a personal loan, your home serves as collateral. This means if you don't keep up with your payments, you risk losing the home.

Home equity loans typically have a fixed interest rate, which means a predictable monthly payment to factor into your budget.

Home Equity Loan Example

To figure out how much money you can get from a home equity loan, you'll need to know your home's current value, your existing mortgage balance, and the maximum combined loan-to-value ratio (CLTV ratio) that your lender accepts. CLTV ratio, expressed as a percentage, is the sum of all outstanding home loan balances (from both the primary mortgage and home equity loan) divided by home value, and the maximum CLTV ratio that lenders allow for is usually about 80%.

To come up with this amount in dollars, you'll need to multiply your home's value by 80% (or 0.80) and subtract the amount you owe on your primary mortgage. Here's an example:

Home value: $300,000
Current mortgage balance: $150,000 (with no other home loans)
Estimated home equity: $150,000
Maximum CLTV ratio: 80%

Potential borrow amount: Up to $90,000 (.80 multiplied by $300,000 minus $150,000)

Keep in mind: When you close on the loan, you'll likely have to pay closing costs. Then, you'll get your funds and begin making principal and interest payments right away. Regular, on-time payments are important since you could face foreclosure if you don't repay the loan or you fall behind on payments.

Home Equity Loan Requirements

While a home equity loan can be a smart way to tap into your home's value, you'll need to meet lender requirements to qualify. Lenders typically look at the following:

Home Equity

Lenders often require you to have at least 20% equity in your home to qualify for a home equity loan. You can estimate your home's equity by taking the value of your home and subtracting your current mortgage balance, plus the balance of any other loans that use your home as collateral, from that amount.

In the case of home equity loans, lenders also measure home equity by looking at CLTV ratio. A lower CLTV ratio reduces the lender's lending risk and can result in a better interest rate for you.

Your lender may require a home appraisal to establish the current value of your home.

Credit Score

You'll need to complete an application and meet credit, income, and financial requirements to get your home equity loan approved. Most lenders require a credit score of at least 620 for this type of loan, but in general, the higher your credit score, the better.

A higher credit score can mean a more favorable interest rate and loan term, as well as the ability to access a higher percentage of your home's equity.

Debt-to-Income Ratio (DTI)

Your debt-to-income ratio (DTI) compares your monthly debts to your monthly income. To figure out your DTI, divide your monthly debt payments by your monthly income. Take the resulting number and convert it to a percentage, and that's your DTI. Typically, lenders prefer a DTI of 43% or less because it gives them confidence that you'll be able to comfortably manage your loan payment.

Pros and Cons of Home Equity Loans

There are pros and cons to think about when it comes to home equity loans. What could work for someone else may not work for you. Here's what to consider:

Home Equity Loan Pros

Potential advantages of a home equity loan include:

• Fixed interest rates: Interest rates on home equity loans are typically fixed, meaning you know roughly how much your payment will be each month. Home equity loan interest rates are also often lower than other types of loans. That's because your home, being collateral for the loan, makes lending less risky.
• Lump-sum payout: Receiving your home equity loan funds upfront means this type of payment is ideal for major expenses with few restrictions on how you use it.
• Potential tax deduction: If you use the loan for qualified home improvements and itemize deductions, you may be able to deduct the interest, subject to IRS rules.

Home Equity Loan Cons

Potential disadvantages of a home equity loan include:

• Two payments: Since a home equity loan is a second mortgage, you'll have an additional payment. And if you sell the home, you'll have to pay the entire balance of both your primary mortgage and the home equity loan.
• Closing costs: Like home purchase loans, but unlike personal loans, home equity loans often require expensive closing costs, which can include appraisal fees, loan origination fees, and others.
• Risk of foreclosure: With your home as collateral, failure to repay a home equity loan means you could lose your home and suffer lasting damage to your credit.

Home Equity Loan Alternatives

Home equity loans aren't the only type of loan that lets you access part of your home's value in cash. Cash out refinances and home equity lines of credit (HELOCs) also allow you to turn home equity into cash on hand.

Cash Out Refinances

Both home equity loans and cash out refinances give you a fixed amount of money as a lump sum at closing.

With a cash out refinance, you'll replace your current mortgage with a new mortgage. When interest rates are lower than the rate on your current mortgage, you can refinance your current principal balance at a lower rate while getting cash from your home's equity. A home equity loan doesn't allow you to do this, as it's a second mortgage that doesn't change the terms of your primary mortgage.

With a cash out refinance, you'll make one payment on one loan each month. Home equity loans require two monthly payments—one on your original purchase loan and one on the home equity loan.

Home Equity Line of Credit (HELOC)

HELOCs are like credit cards in many ways. When you get a HELOC, you're approved to borrow an amount of money—up to a certain limit, for a period of time—and you can use that line of credit for cash whenever you need it.

Because of their withdrawal and repayment periods, HELOCs give you the flexibility to choose how much money you'll borrow and when you'll borrow it, unlike home equity loans and cash out refinances. For example, if you're using a home equity loan for home renovations and costs exceed initial projections, you won't have access to more funds like you would with a HELOC's revolving line of credit.

HELOCs often have variable interest rates. This means that the cost of your interest payments can change over the life of the loan.

Home Equity Loan Rates

The rate you might get on a home equity loan is affected by many factors, including current market rates, your lender's standards, your credit score, and your finances. When you're looking at rates on home equity loans, compare the APR and the interest rate.

APR (or annual percentage rate) takes into account the closing costs you might have to pay to get a home equity loan. An APR that's much higher than the interest rate on a home equity loan can signal that the loan comes with high closing costs.

Home Equity Loan FAQs

Here are some answers to questions borrowers often have when researching home equity loans:

What Credit Score Is Needed for a Home Equity Loan?

The credit score required to qualify for a home equity loan will vary from lender to lender, but in general, they'll prefer a score of at least 620. You may still be able to get a home equity loan with a lower credit score, but a higher credit score could get you a better loan term and interest rate.

Is a HELOC or Home Equity Loan Better?

Determining if a home equity loan or HELOC is better for you depends on your financial goals and needs. For example, home equity loans often have fixed interest rates and predictable monthly payments, unlike HELOCs, which usually come with variable interest rates. However, HELOCs allow you to borrow and repay as needed within a certain period of time, while home equity loans provide one lump sum at closing.

Is It a Good Idea to Take Equity out of Your Home?

Using your home's equity to access funds can help you achieve goals like paying for home repairs or renovations, education, or unexpected medical care. You can also use these funds to consolidate high-interest debt. However, there are many factors to consider, such as your eligibility and ability to repay more money.

Final Thoughts on Home Equity Loans

Tapping into your home equity is a powerful tool for financing a number of major expenses.

While Freedom Mortgage doesn't offer HELOCs or home equity loans at this time, we can help you access your home's equity with a cash out refinance for a conventional, Department of Veterans Affairs (VA), or Federal Housing Administration (FHA) loan.

Research your options and choose the one that's right for your situation, and if a cash out refinance is what you need, we can help you get started today.