How Does a Home Equity Loan Work?
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ExpertiseStefanie began her career as a journalist, reporting on options, futures, and pension funds, and most recently worked as a writer and SEO content strategist at a digital marketing agency. In her free time, she enjoys teaching Pilates and spending time with her daughter and Siberian Husky.
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If you need access to money for a big expense, using your home’s equity can be a great way to do so at a lower interest rate than with a personal loan or credit card.
Think of a home equity loan as a second mortgage. It allows you to borrow against the value of your home to gain access to a lump sum of money (as opposed to a home equity line of credit, which operates more like a credit card).
In this article, you’ll learn:
- What is home equity?
- What is a home equity loan?
- Am I eligible for a home equity loan?
- How much can I borrow from a home equity loan?
What Is Home Equity?
Home equity is the amount of your home that’s been paid off. Your home equity can increase either by the market value of your home going up (i.e. making updates to your home) or by paying more money toward your mortgage.
How to Calculate Your Home Equity
Your home equity is the market value of your home minus any outstanding mortgages. For example, if your home was appraised for $400,000 and you have a loan balance of $150,000, you have $250,000 in equity.
What Is a Home Equity Loan?
A home equity loan is a loan that uses your home as collateral. You pay the loan back in fixed monthly payments. The amount you’re able to take out of a home equity loan depends on factors such as your credit history, income, and your home’s current market value.
By securing a loan with your home, you’ll be able to take out money at a low interest rate since it isn’t risky to the lender. If you stop making payments, the lender can foreclose on your home.
Pros of home equity loans
- Predictable monthly payments with a defined schedule
- Fixed interest rates
- Tax-deductible if used for home improvement purposes
Cons of home equity loans
- If you fall behind on payments, you can lose your home
- It’s another mortgage to pay
- You have to pay closing costs and fees
Am I Eligible For a Home Equity Loan?
Home equity loan eligibility requirements include:
- A max loan-to-value ratio (LTV) of 80%, or 20% equity in your home
- A credit score of at least 620-if you have a score lower than this, it will be hard to qualify
- Ability to demonstrate you’ll be able to pay back the loan
- Debt-to-income ratio that doesn’t exceed 43%
How do I pay back a home equity loan?
You pay back a home equity loan at a fixed interest rate in regular monthly payments. So, you’ll pay the exact same amount month to month without worrying about rate fluctuations.
How long do I have to pay it off?
Home equity loan repayment terms generally range from 5 to 20 years, though it’s also possible to get a 30-year term.
Will a home equity loan hurt my credit score?
You should expect to see a very small decrease in your credit score from your home equity loan, but this dip will most likely be temporary.
How long does it take to process a home equity loan?
From application to closing, it can take anywhere from 2 to 4 weeks for a home equity loan to be processed.
How Much Can I Borrow From a Home Equity Loan?
Banks will typically let you borrow 80% of your home’s equity. So, if you have $80,000 worth of equity in your home, you’ll qualify for a $64,000 loan ($80,000 x 0.80=$64,000).
What home equity fees should I expect to pay?
Fees associated with getting a home equity loan include:
- Appraisal fees
- Application fees
- Title search and title insurance fees
- Credit report fees
- Closing costs (including attorney, title insurance, and mortgage preparation fees)
Home equity loan red flags
Three red flags to watch out for when looking for a home equity loan are:
- Balloon payments: Some lenders offer small monthly payments, but require a large ‘balloon’ payment at the end of a loan period.
- Financing offered by home improvement contractors: Predatory contractors might offer to give you a loan to help finance work on your home. They will often try to pressure borrowers into signing these loans without providing them the full details, in addition to doing sub-par work.
- Unlicensed lenders: Call your state’s office of financial services or institutions to make sure that the lender is licensed, and check whether complaints have been made against them.