Most of us know there are many advantages associated with being a homeowner, including the ability to access the equity in your home through a home equity loan.
Of course, being a homeowner doesn’t automatically qualify you for this type of loan. You must have a certain percentage of equity, plus the income and credit to support the loan.
This article will walk you through what a home equity loan is, discuss the pros and cons, and outline what you may need to qualify for a home equity loan.
What Is a Home Equity Loan?
A home equity loan is a loan you take out against the equity in your home. You use the value of your home to get a lump sum payment from a lender. Many people use the funds to make home improvements, consolidate debt, meet large expenses, or even pay college tuition.
You can determine the equity of your home by taking the value of your home and subtracting the mortgage balance.
Here’s an example of home equity calculation:
- Current Market Value of Home: $100,000
- Current Mortgage Balance: $50,000
- Equity: $50,000
To find out your home’s value, you can use online property value tools, or check with your county or city real estate assessment office. But the most accurate method is to get an official appraisal, which typically costs $300 to $400.
In the example above, the homeowner could potentially get a loan amount of $50,000. Sounds simple, right? Well, there’s a bit more to it than that, but this example provides a general idea of the concept. There are several other factors we will discuss below and some tips to help you decide if a home equity loan is right for you.
When Should I Consider a Home Equity Loan?
The thought of borrowing thousands of dollars at a competitive rate can be very appealing when you’re looking to improve your home or pay for other expenses, but home equity loans aren’t the best option for everyone.
Keep in mind that a home equity line of credit (HELOC) is another great option if you would prefer an ongoing source of funds instead of a lump sum payment. For both a home equity loan and HELOC, you want to try and get the best rate possible to keep borrowing costs down.
Pros of Home Equity Loans
With this type of loan, you tend to qualify for lower interest rates compared to that of a credit card or even a personal loan with a bank or credit union. Lower interest rates lead to less money paid over the life of the loan.
Compared to unsecured loans, it may be easier to meet home equity loan requirements and be approved because your home serves as collateral in case you fail to make your payments.
You will likely get a fixed interest rate and steady monthly payments, while a HELOC rate is usually variable. Also, the interest may be tax deductible when the funds are used for significant home improvements.
Cons of Home Equity Loans
You’re incurring additional debt. Just like an auto loan, you will have a monthly payment to repay the loan on top of your mortgage payments. If you fail to keep up with your payments, your credit can be negatively impacted or your lender may attempt to seize your asset (or home).
You usually need to pay fees as part of the home equity loan process, including closing costs which can amount to a few thousand dollars. Make sure you check with your lender about potential fees, terms, and conditions before applying for a home equity loan.
What to Use a Home Equity Loan For
Now that you understand the basic pros and cons of taking out a home equity loan, it’s important to note that the funds shouldn’t be used for insignificant purchases.
- Upgrading your home or making necessary home improvements
- Paying off medical bills
- Consolidating credit card debt
- College tuition and fees
- Weddings and vacations
- Unforeseen expenses or emergencies so you don’t need to touch your savings account
You may also consider a home equity loan for buying a vehicle but it’s a good idea to explore traditional auto financing first.
Factors for Meeting Home Equity Loan Requirements
Having equity in your home doesn’t mean you will instantly qualify for a home equity loan. You must meet specific qualifications, just as when you took out your mortgage or any other loan you’ve acquired.
The minimum credit score is generally 620. It is more challenging to qualify for a home equity loan with a credit score below 620. The closer your score gets to 700, the more likely you are to meet home equity loan requirements.
As with any loan, you must demonstrate your ability to repay it. Your bank or credit union will verify your income and review your debt to income (DTI) ratio, which is the amount of debt you have compared to your income.
It’s recommended your DTI ratio is less than 50%. Here is a debt-to-income calculator to determine yours.
Your loan to value ratio, or LTV, can be a max of 80%, which means you have 20% equity in your home. Your LTV is calculated by taking your loan balance, adding it to the amount you want to borrow, and dividing it by your home’s market value.
Here’s a loan to value ratio example:
- Home value: $100,000
- Mortgage balance: $50,000
- Home equity loan desired: $20,000
You take the desired amount ($20,000) + the mortgage balance ($50,000) = $70,000
Then divide $70,000 by the value ($100,000) = a loan to value ratio of 70%, which is within the requirements.
Meeting Home Equity Loan Requirements
While these are basic home equity loan requirements, all credit unions and lenders have minimum qualifications, so you should shop around to find the best home equity products and services for you.
Deciding to take out a home equity loan is a big decision. The funds you borrow can make a huge difference in your life, whether you’re remodeling your home or paying off high-interest debt. Click below to learn more about how to use your home equity loan funds!