How Home Equity Loans Work
The beauty of buying your dream home is that, beyond serving as a happy haven for you and your family, it can grow into something you can use to access cash down the road.
Whether through development, area improvement or paying down your mortgage over time, when your home’s market value becomes greater than the value of your mortgage, you have equity in your home — equity you can use to access cash in the form of home equity loans, home equity lines of credit and cash-out refinancing.
These loans can be used for all sorts of things, including home renovations, debt consolidation, emergencies or simply stored as a rainy day fund, which explains why more than 10 million people are predicted to take advantage of their home equity over the next five years.
What Is a Home Equity Loan?
Both home equity loans and home equity lines of credit are loans borrowed against the equity of your home, mobile home, or rental property. The home itself acts as collateral. Therefore, to be able to get a home equity loan, you have to have a substantial amount of equity available to you.
Fortunately, understanding your available equity is simple: just subtract your debts secured by your house (such as your mortgage) from the current market value of your home. The remaining amount is your total equity.
What Types of Home Equity Loans Are There?
There are four options for those interested in home equity loans:
- Fixed-rate home equity loan
- Home equity line of credit (HELOC)
- Cash-out refinance loan
- Home equity investment
Fixed-rate home equity loan
This is the most common type of home equity loan, essentially taking the form of a second mortgage in which you take out a lump sum and pay it back every month at a fixed rate over a period of 5-30 years. In order to help you assess this option, home equity loan providers often provide home equity calculators that can help you figure out how much you may be able to borrow.
If you’re interested in this option, get home equity loan quotes from a few companies. Then, compare home equity loan rates and terms to find your best fit.
Home equity line of credit (HELOC)
A home equity line of credit doesn’t require you take out the entire lump sum like a traditional home equity loan. Instead, a HELOC allows you to borrow up to a certain amount, typically over a 5 to 10-year period. Then, you can simply pay off the interest (or principal) every month, similar to how you pay off a credit card. When calculating a HELOC payment, many home equity lenders have free online calculators that can help.
If you’re interested in this option, apply for a HELOC from a top home equity loan lender. Before completing your HELOC application, compare a few lenders to find the lowest HELOC rates available.
Cash-out refinance loan
A cash-out refinance loan gives you a new mortgage for more than your previous mortgage balance and the difference is paid to you in cash. So, instead of creating a second mortgage on your home – as a home equity loan does – a cash-out refinance loan converts your mortgage into a new loan.
Home equity investment
Want to tap into your home’s equity without taking out a loan? A home equity investment is an alternative worth considering. In exchange for a portion of the equity you have in your home, a home equity investment, also known as a home equity alternative, gives you cash for a share of your home’s future value.
There’s no interest and no monthly payments because it isn’t a loan. By the end of the agreement, you pay back the investment. Some homeowners sell their homes, while others buy out the investment through other means like savings.
What Can You Use Home Equity Loans For?
There are many uses for home equity loans, but the most common reasons people choose to borrow against the equity in their homes include:
- Credit card and other debt consolidation
- Home renovations
- A down payment for another home
- Rainy day and emergency funds
Of course, what you’re able to do with your home equity loan depends on how much you’re able to borrow in the first place, which is explained more in-depth below.
How Do You Get a Home Equity Loan?
Getting a home equity loan usually requires you to qualify in three main areas:
- Credit score
- Debt amount
- Equity amount
According to Wells Fargo, you’ll get the best home equity loan rates with an “excellent” credit score of 760 and up; decent rates with a “good” score of 700 to 759; and less favorable rates with anything below a credit score of 621. The exact credit scores to qualify for specific rates will vary a bit from lender to lender, so it’s possible for those with bad credit to find options.
As you might expect, already having too much debt will disqualify you from most loan options. This is why most lenders and banks that do HELOC and home equity loans require that your debts don’t eat up more than 43% of your income.
You likely have an idea of how much you need to borrow in the form of a home equity loan. Because most banks won’t lend more than 80% of the value of a home, minus the current mortgage amount, it’s worth doing some quick calculations to understand the value of your home and if applying for a home equity loan is even worth it in the first place.
Let’s say you have a home with a market value of $600,000 and a mortgage of $400,000. To understand 80% of the value of your home, simply multiply $600,000 x .80. This gives you $480,000. From there, you subtract your mortgage of $400,000 to give you $80,000.
Therefore, in this example, $80,000 is how much home equity you are likely able to access through a loan or line of credit. You can cross-reference this with how much you think you’ll need to understand if a home equity loan is worth it.
Are There Any Risks to Home Equity Loans?
Some types of home equity loans can be riskier than others. For example, fixed-rate home equity loans, which have you pay the same interest rate from the day you take out your loan to the day you finish paying it off, may be considered more prudent than adjustable-rate loans since it’s not possible to know what interest rates will be in the future.
Like with any other loans, home equity loans come with their share of risks. For example, not paying home equity loans can result in the foreclosure of your home. On the other hand, because it’s considered a secured loan, you’re likely to get better rates than you would with a credit card or personal loan.
Find Low-Rate HELOCs and Home Equity Loans
If you’re interested in getting a HELOC or home equity loan, then you can view rates from top-rated providers today. Starting the process is as simple as that.