Questions to Ask Yourself before Taking Out a Home Equity Loan
Whether through intention or pure luck, you may be among the lucky people whose home is now worth more on the market than the remaining balance on your mortgage. If this is the case — congratulations! — you now officially have equity in your home.
With this equity, you can now pull cash out of your home in the form of a home equity loan to pursue all kinds of projects, from home improvement to consolidating debt, to simply saving for a rainy day.
However, just because you have equity in your home doesn’t necessarily mean you should borrow against it. To help you understand whether or not taking out a home equity loan is truly the right decision, we gathered and answered the seven most important questions you should ask yourself before committing to a home equity loan.
1. Do I really need a home equity loan?
It’s important to consider your goal to understand whether or not a home equity loan is truly the right option.
The most common and justified reasons people choose to borrow against the equity in their homes are:
- To consolidate higher cost credit card and other debt
- For home renovations
- To refinance existing home equity loans
- For a down payment for another home
- For a rainy day/emergency fund
Although not as common, you can also successfully use a home equity loan for other, non-home-related ventures, such as to fund a business or pay for your education, as long as you think that education or business will raise your income.
A large amount of spending in general, on the other hand, isn’t important enough to justify borrowing against your home in most cases. For example, things like vacations, weddings, luxuries, and consumer goods should be paid for out of current income and savings instead of with a home equity loan.
Similarly, avoid using a home equity loan as a bandage for an underlying problem, such as overspending or living outside of your means.
2. Do I understand the risks?
Like with any other loans, home equity loans come with their share of risks. For example, if you don’t keep up with payments on your credit cards it can result in a negatively affected credit score, but not paying home equity loans can result in the foreclosure of your home.
Furthermore, some types of home equity loans are riskier than others. For example, fixed-rate home equity loans, where you pay the same interest rate from the day you to take out your loan to the day you finish paying it off, are arguably less risky than variable-rate loans. This is because while you may benefit from lower interest rates when you first take out your loan, interest rates are unpredictable and could rise in the future.
3. Do I even qualify for a home equity loan?
To qualify for a home equity loan, you first have to have equity that equates to around 15% to 20% of your home’s value. 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.
Beyond this, you also typically have to have a credit score of 620 or higher, as well as a debt-to-income ratio (the percentage of your monthly income that goes to paying your debts) of 36% to 43%.
However, it’s worth noting that you can get a home equity loan with bad credit if you are upstanding in other areas, such as having a very low debt-to-income ratio or a lot of equity in your home. That said, people with bad credit can expect much higher interest rates.
4. How much can I borrow using my home’s equity?
Because most banks won’t lend more than 80% of the value of your home, minus the current mortgage amount, it’s worth doing some quick calculations to understand how much you’re likely able to borrow in the form of a home equity loan.
Let’s assume you have a home with a market value of $600,000 and a mortgage of $400,000. To calculate 80% of the value of your home, simply multiply .80 x $600,000. This gives you $480,000. Next you subtract your mortgage of $400,000 to give you $80,000.
Therefore, in this example, $80,000 is about how much money you are likely able to get through a home equity loan.
5. What type of home loan is best for me?
There are three primary ways to access your home’s equity:
- 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.
- 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 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 your credit card.
- Cash-out mortgage refinance: 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. And instead of creating a second mortgage on your home–as does a home equity loan–a cash-out refinance loan converts your mortgage into a separate, larger one.
Depending on your goals, some ways are better than others. For example, if you don’t need everything upfront, you can opt for a HELOC and draw funds only as you need them. However, if you need to refinance but also need access to fast cash, then a cash-out refinance might make more sense.
Regardless, it’s always good practice to find out how long the process will take before you can access your cash.
5. How long will it take to pay off my home equity loan?
It’s also important to consider how long it will take to pay off your loan, as this can factor in when deciding the best loan option. For example, if you can pay off what you owe in five years or less, a HELOC may be your best option because HELOCs are comparatively cheap to set up.
However, if you foresee taking longer than five years – say more in the neighborhood of 15 years – then a home equity loan may make more sense. This is because home equity loans come with a fixed interest rate, so you can at least have the assurance that your monthly payments won’t become more expensive.
For those estimating an even longer repayment period, a cash-out refinance will likely serve you well, despite having higher closing costs and potentially changing the rate on your primary mortgage.
6. How will a home equity loan affect my credit?
Taking out a home equity loan can affect your credit score in two main ways.
The first is if you miss payments, which will negatively affect your credit score. The second is related to your debt-to-income ratio, in the sense that having the monthly payments associated with your home equity loan will take up more of your income and can affect your ability to borrow in other situations.
7. Will I have to pay any extra costs with a home equity loan?
Costs will differ depending on the type of loan and party being dealt with, but generally, you may be required to pay any of the following: closing costs, annual fees, cancellation fees, home appraisal expenses and taxes.
To understand exactly what you will pay, be sure to ask the lender you’re dealing with. Helpfully, many online services now will even give you a full price breakdown in the estimate phase.