What is a Home Equity Loan?

What is a Home Loan?

A home equity loan is a type of loan that lets you borrow against the present value of your home, often at a low, fixed interest rate.

As a “second mortgage,” a home equity loan is typically a smaller second loan taken on top of your main mortgage. This allows you to take advantage of the value of your home without changing the interest rate or terms of your main mortgage. You can also take out a home equity loan when your house is fully paid off and only borrow the amount you want to pay off.

A home equity loan is one of the best ways to free up equity in your home without selling or refinancing the property.

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Definition of home equity loan

A home equity loan is a type of mortgage that is secured by your home equity. Equity is the difference between the value of your home and what you owe the mortgage lender. If you owe your mortgage lender $100,000 and your home is valued at $250,000, you have $150,000 in equity.

Unlike a cash-out refinance, a home equity loan is used solely for borrowing. It does not refinance your existing mortgage balance, nor does it change the interest rate and term of your primary mortgage. Rather, it is a separate loan with its own interest rate and monthly payment. For this reason, a home equity loan is called a “second mortgage.”

Smart uses for a home equity loan include debt consolidation, home improvement, paying for college, and starting a business. These types of loans are not typically recommended for luxury items, vacations, or risky investments.

This is how home equity loans work

A home equity loan is a lump sum installment loan, meaning you receive the entire loan amount up front and pay it back in equal monthly installments until the balance is cleared.

Home equity loans typically have fixed interest rates and fixed monthly payments with terms ranging from five to 30 years. You can deduct interest paid on a home equity loan, but only if you’re using funds to buy or build a property, or to “substantially improve” a property you already own.

Home equity loans are distinct from home equity lines of credit (HELOCs), which allow borrowers to access a line of credit when needed. They are also different from cash-out refinancing, which involves replacing an existing mortgage with a new one.

Because you’re taking out another loan against the property, home equity loans are also known as second mortgages. Your main mortgage remains the “first lien” and your second mortgage is the “subordinate lien”. If you sell the home before paying off a home equity loan, use the proceeds of the sale to pay off the balance.

Home equity loans are attractive because they typically have lower interest rates compared to other types of debt, such as credit cards and personal loans. However, since your home is used as collateral, failure to make loan payments could result in foreclosure.

How Much of a Home Loan Can I Get?

The amount you can borrow with a home equity loan depends on how much equity you have built up in your home and what you own on your primary mortgage. Most lenders limit your combined loan-to-value (CLTV) ratio to around 80%, which means your main mortgage and home equity loan combined cannot account for more than 80% of the home’s value.

Let’s say your home is valued at $400,000 and you currently owe $150,000 on your main mortgage. To find your maximum home loan amount:

  • house value: $400,000
  • Maximum combined loan amount: $320,000 (80% of value)
  • Existing mortgage balance: $150,000
  • Maximum Home Loan: $170,000 (max CLTV minus existing mortgage)

The amount you can borrow also depends on your credit score, interest rate, and debt-to-income ratio (DTI).

When it comes to DTI, your lender reviews your monthly loan and credit card payments, and then compares that number to your income to determine affordability. Because of this, two borrowers with similar incomes and the same amount of equity may qualify for different sized home loans –– especially if one borrower has more debt than the other.

Requirements for a home loan

Equity alone does not qualify anyone for a home equity loan. Requirements vary from lender to lender, but typically include:

  • At least 20% equity in the home
  • A debt-to-income ratio of 43% or less
  • Meet the lender’s minimum credit requirement
  • Proof of income or ability to repay

The creditworthiness requirements for a home equity loan vary greatly depending on the lender. Some lenders allow credit scores as low as 620, while others require a score in the mid-600s or higher.

If you have a lower score, you need to shop around and compare lenders. It might be easier to qualify if you have compensating factors such as: B. small debts or extensive assets.

How to get a home loan

Here are seven steps to applying for a home equity loan:

1. Check your finances

A home equity loan adds to your monthly debt, so check your finances to see if you can handle the extra payment. Also, check your credit report and credit history. You usually need a credit score of at least 620 to qualify. Paying your bills on time, paying credit cards, and contesting errors on your credit report can increase your score.

2. Determine how much you want to borrow

Your lender ultimately decides how much of your equity you can borrow. Still, think of a number so you don’t borrow more than you need to. Think about how much cash you need to meet your financial goals and what monthly payment you’re comfortable with — especially if you’re still paying off your first mortgage.

3. Gather your papers

You must submit supporting documentation such as payslips, tax returns, W-2s, and bank statements. Lenders use this information to calculate your debt-to-income ratio and affordability. If you have your documents ready on time, your application will be approved more quickly.

4. Compare home equity lenders

Home equity loan requirements and terms may vary by lender. Get at least three quotes from different lenders, then compare interest rates, terms, and creditworthiness requirements. You can get a quote from your current lender, as well as other banks, credit unions, mortgage companies, and online lenders.

5. Go through the underwriting process

Your lender will carefully review your income statements, bank statements, credit history, and debts to see if you qualify for a home equity loan and determine how much you can borrow.

6. Wait for the assessment

Your mortgage lender will commission a real estate appraisal to determine the value of your home. This is required before approving your application.

7. Complete the loan

Once your lender has completed the underwriting process and received the assessment report, the final step is closing. You sign the loan documents and receive the lump sum payment.

After you close a home equity loan, start making regular monthly payments. If you currently have a mortgage loan, your home equity loan is a second payment on top of your regular mortgage payment. If your house has been paid off, you only pay the home equity loan.

Home equity loan FAQs

Is a Home Loan a Mortgage?

A home loan is a type of mortgage loan. It is not a primary mortgage like you use when buying a home, but a secondary mortgage secured by the property. This subordinate lien is also called a second mortgage. Because your property serves as collateral for a home equity loan, failure to repay the loan could result in foreclosure.

How long does it take to get a home equity loan?

On average, it can take anywhere from two to six weeks for a home equity loan to close. The process of getting a home loan can vary from lender to lender. Factors affecting the schedule include a lender’s underwriting process, appraisers’ schedules, scheduling conflicts, and delays in filing.

What is the Average Home Equity Loan Interest Rate?

Home equity interest rates are typically slightly higher than standard mortgage interest rates. However, they tend to be significantly lower than other unsecured forms of borrowing such as credit cards and personal loans. Home equity loan installments are fixed, which means your interest rate and payment will remain the same throughout the life of the loan.

Is a Home Loan Tax Deductible?

Home equity loans are only tax deductible under certain circumstances. Currently, you can only deduct interest on a home loan if you are using the funds to purchase or build a primary or secondary home, or if you are using funds to substantially improve a primary or secondary home. Beginning in 2022, married couples who apply together can deduct interest on up to $750,000 of mortgage debt, and married couples who apply separately can deduct interest on up to $375,000 of mortgage debt.

Can You Get a Home Loan With Bad Credit?

Most lenders require a minimum credit score in the mid to high range of 600 for a home equity loan, but it may be possible to be approved with a lower score. Some lenders will approve homeowners with a score as low as 620. However, you’ll have to shop around to find these lenders. It’s easier to get approved with bad credit if you have compensating factors. These include a stable income and low consumer debt.

Which lenders offer home equity loans?

Home equity loans are widely available, and many types of lenders offer this option. These include banks, credit unions, mortgage companies, and online lenders. First, check with your current mortgage lender and your bank or credit union. Compare their rates, terms and requirements. Get at least three interest rate quotes before deciding on a lender.

The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for the products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policies or position of Full Beaker, its officers, parent companies or affiliates.

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