Home Equity Loans

The American dream of home ownership can be expensive. A mortgage often ties up nearly all your income, leaving little left over for anything else. You may find yourself relying on credit cards or trying to figure out how you’ll cover the next big expense. Because this is not at all uncommon, several tools are available to help homeowners obtain cash when they need it. One such tool is the home equity loan. This and other types of second mortgages have helped millions of homeowners finance renovations, consolidate debt, and fund unexpected expenses.

If you’re wondering whether one of these options may be right for you, consider speaking with a real estate attorney in your state. They can help identify potential risks and hidden costs associated with each arrangement. They can also help you understand repayment terms and negotiate with lenders, as appropriate.

In the meantime, let’s take a look at what home equity loans are and how they work. We’ll also compare them to other types of second mortgages, like home equity lines of credit (HELOCs).

What Is a Home Equity Loan?

A home equity loan is a type of second mortgage that lets homeowners borrow money using their house as collateral. Think of it as a way to turn part of your home’s value into cash.

With most home equity loans, you’ll receive a lump sum of money upfront that you pay back over time with fixed monthly payments. A home equity loan places a second lien on your home, meaning the lender has a legal claim to your property as collateral until you repay the loan.

Equity

To understand how a home equity loan works, you need to know about equity. Equity is the difference between your home’s market value and what you still owe on your current mortgage. For example, if the value of your house is $300,000, and you still owe $200,000 on your first mortgage, you have $100,000 in equity.

Unlike your original mortgage, where you likely needed a down payment to buy the new home, a home equity loan uses your existing equity as security, or collateral. This reduces your equity because the loan essentially converts part of your ownership stake in the home into debt.

Are Home Equity Loans Only for Home Expenses?

No. You can use a home equity loan for virtually any purpose, but they’re most commonly used for home improvements, debt consolidation, education expenses, or other big purchases.

People use a home equity loan for debt consolidation by applying all or part of the lump sum toward multiple debts with higher interest rates, like credit card balances and personal loans.

What Qualifications Do I Need For a Home Equity Loan?

Qualifying requirements can vary widely from lender to lender, but most consider several factors. These typically include:

• Your current home’s appraised value: Lenders usually hire an appraiser to determine the current market value of your home. This is used to determine how much you may borrow.
• Credit score: A higher credit score usually means better loan terms and lower interest rates. Lenders typically seek a credit score of at least 620.
• Debt-to-income ratio (DTI): This is the percentage of your gross monthly income that goes toward all debt payments, including the proposed home equity loan. Most lenders require a DTI of 43% or lower.
• Amount of equity: You need enough equity built up in your home. Lenders ordinarily seek 15-20%.
• Income and employment: You must show proof of income and steady employment. This is used to calculate DTI.

Essentially, mortgage lenders want to make sure you’ll have enough income to comfortably make your new loan payment along with your regular mortgage payment (and everything else).

How Much Can I Borrow in a Home Equity Loan?

The amount of money you can borrow depends on your lender’s requirements. For most lenders, it largely turns on the amount of equity you have in your current home and the loan-to-value ratio (LTV). The LTV compares the loan amount you’re requesting to your home’s appraised value. Lenders typically want to see a low LTV, meaning you have a significant amount of equity in your home.

Most will allow you to borrow up to 80-85% of your home’s value, minus your mortgage balance.

For example, let’s say your home is worth $300,000, and you have $100,000 in equity. This means your mortgage balance is $200,000. If the lender has an LTV ratio of 80%, you could potentially borrow an additional $40,000 (80% of $300,000 is $240,000. $240,000 minus a mortgage balance of $200,000 equals $40,000).

How Do You Repay a Home Equity Loan?

The term for a home equity loan usually ranges from five to 30 years. You’ll typically have a fixed interest rate for the entire repayment period, which keeps your payments the same during this period of time. These fixed monthly payments usually include both principal and interest.

How Do I Know if a Home Equity Loan Is Right for Me?

A home equity loan isn’t for everyone. It offers different features from other types of loans or second mortgages. Below we’ll review some factors you’ll want to keep in mind when considering a home equity loan.

Benefits

Many people go the home equity loan route because it has several benefits. These typically include:

• No new down payment
• Lower interest rates than debt from credit cards or personal loans
• Fixed monthly payments for budgeting ease
• Lump sum funds to help with big expenses or debt consolidation
• Tax-deductible interest payments for home improvements

Many borrowers like the idea of reducing their taxable income. If you’re hoping to avail yourself of this tax deduction, you’ll want to consult with a tax attorney to ensure compliance.

Disadvantages

Some people avoid home equity loans because of certain drawbacks. These might include:

• Foreclosure risk: Since your home is collateral, you could lose it to foreclosure if you fail to make your loan payments.
• Upfront costs: There are usually closing costs, application fees, and origination fees, similar to your first mortgage.
• Fixed loan amount: Once you get your lump sum, you can’t borrow more without applying for another loan.
• Liens: The lender places a lien on your home, which must be paid off if you sell or refinance.

While a home equity loan is right for some homeowners, many find that a home equity line of credit suits their needs better.

HELOCs

A HELOC is another way to borrow against your home. A HELOC is a revolving line of credit that works much like a credit card. You get a credit limit and can borrow against it during the draw period, usually five to 10 years. In this period, you usually make interest-only payments.

Once the draw period ends, you enter the repayment period. This can last between 10 and 20 years. In repayment, you make installment payments that include both principal and interest.

HELOCs typically have variable interest rates. This means your payments can change over time. This is different from home equity loans, which usually offer fixed monthly payments for the entire term.

Some lenders may let you lock in a fixed interest rate on part of your HELOC loan balance.

Second Mortgages

Both HELOCs and home equity loans are types of second mortgages. Like your first mortgage, a second mortgage uses your home as collateral, creating a second lien on it.

Other less common types of second mortgages include:

• Piggyback loan: Second loan taken by homebuyers to avoid private mortgage insurance
• Wraparound mortgage: Seller-financing tool that combines a second loan with the first mortgage

Many homeowners also consider cash-out refinancing when discussing second mortgage options.

Cash-Out Refinance

While not technically a second mortgage, cash-out refinancing is another way to tap into your home’s equity for cash.

In cash-out refinancing, you basically replace your current home loan with a new, bigger loan. You use part of the new loan to pay off your old mortgage, and the extra money goes to you as cash.

This may sound great, but you’ll now have a larger mortgage to pay back with higher monthly payments. So, it’s essential you consider the pros and cons before taking this leap.

Legal Guidance

As you weigh your options, it’s a good idea to connect with an experienced real estate attorney licensed in your state. They can protect your interests and help ensure that you’re making informed decisions.

You’ll want a qualified advocate who can communicate with lenders on your behalf and negotiate better terms, such as a lower interest rate or more favorable repayment terms. A credible legal advisor can help you steer clear of predatory lending practices and sort through the financial vehicles that match your situation.

Of course, finances can involve extremely private matters. So, you’ll want to identify a qualified attorney you can trust. FindLaw’s directory of real estate lawyers can help get you started. Just click on your state, then city, to view information about local experts in your area.

Enlist the help of someone who can help you understand alternatives and the practical implications of another loan. They just might be your most important ally as you move forward.