How to Get A Home Equity Loan. According to the Federal Reserve’s Flow of Funds Report, Americans collectively have $21.5 trillion in home equity. According to mortgage data provider Black Knight, about $6.5 trillion of that or more than $120,000 per mortgage holder could be tapped for cash.
Home equity is a significant source of wealth in the United States. It is calculated by subtracting what is still owed on your mortgage from the amount the home could sell for. Homeowners can, of course, access their equity by selling, but those who don’t want to move can access some of their equity through a loan or a line of credit. Borrowers receive the entire amount as a lump sum with a home equity loan, whereas a home equity line of credit is a pool of funds that can be drawn from as needed.
Home equity loans or lines of credit have lower interest rates than credit cards or personal loans, but they are higher than first mortgages. Homeowners frequently use these loans to pay for home improvement projects or to cover large expenses such as college, but they can be risky and difficult to qualify for — especially in a tough economy. Before taking out one of these loans, borrowers should consider closing costs such as origination and appraisal fees, which typically range from 2% to 5% of the loan value.
What is a home equity loan?
A home equity loan, also known as a second mortgage, functions similarly to a first mortgage. The loan is for a set amount of money, paid in one lump sum, and is secured by your home. You will have a fixed interest rate and will repay the loan with pre-set monthly payments over a five to thirty-year period.
In normal circumstances, lenders will allow up to 85 percent of the home’s market value to be borrowed. During the coronavirus pandemic, the limit was reduced to 80 percent or less at times. That is, your loan amount plus your mortgage balance cannot exceed 80% of the market value. So, if your house appraises for $200,000 and your mortgage balance is $100,000, you may be able to borrow up to $60,000. (The exact amount you can borrow will also be determined by your income, credit score, and the value of your home.)
Because home equity loans are paid out in full, they are best suited for large one-time expenses — ideally, when you know exactly how much money you require. Although it is risky, some home sellers use home equity loans to put money down on a new home while waiting for the sale of their current home to close.
What is a home equity line of credit?
A home equity line of credit commonly abbreviated as HELOC is a revolving line of credit rather than a fixed loan. It’s similar to a credit card, but the collateral is your home.
A credit limit exists on a HELOC. You can borrow up to that amount by writing a check or using the account’s credit card. The balance on a HELOC rises as you use it to make purchases, and your available credit rises as you repay the debt. As a result, HELOCs are ideal for financing ongoing home improvement projects or other recurring expenses.
The full line plus your mortgage balance, similar to a home equity loan, can equal up to 80% of your home’s appraised market value. You only pay interest on the amount drawn from the line. Keep in mind that your lender may impose a minimum withdrawal requirement when you open the account or later. Make sure to inquire.
Inquire about the length of your draw and repayment periods as well. Typically, you can borrow from the line for a period of five to ten years. Be aware that you may be required to repay the debt in full at the end of the draw period or to make a balloon payment at the end of the loan. Other HELOCs have a payback period of 10 to 20 years after the draw period ends, making them a safer bet.
It is common for lenders to require only interest payments during the draw period, implying that you are not making any progress toward paying down your balance. (Making extra principal payments will save you money on interest and help you pay off your debt faster.)
HELOC interest rates typically begin lower than home equity loans (in October the average rate on a HELOC was 4.55 percent versus 5.10 percent on a home equity loan). Most HELOCs, on the other hand, have variable interest rates rather than fixed interest rates. This may result in a lower interest rate and monthly payment at first, but the rate may change from month to month. Inquire whether the rate you’re being offered is a one-time deal.
Following the introductory period, most lenders base HELOC rates on the US Prime Rate, which is an index of corporate rates charged by large banks. Lenders then add a one-of-a-kind margin that is determined at the start of your loan. Check the cap on interest rate changes over the life of the loan and ask for your individual margin rate.
How to get a home equity loan or home equity line of credit
During the coronavirus pandemic, the requirements for obtaining a home equity loan or a HELOC have become more stringent. Here are the steps you should take when applying.
Step 1: Check your home equity
You must have equity in your home to qualify for a home equity loan or a HELOC. Borrowers who are upside down on their first mortgage — that is, owe more than the home is currently worth — are ineligible for this loan. It’s also unlikely to be an option for first-time buyers who haven’t yet built equity through appreciation or regular mortgage payments. Keeping as much equity as possible is also a good insurance policy against a drop in home values, so try not to borrow more than you really need. Most lenders limit home equity loans to $250,000 or less.
Step 2: Check your credit score
Borrowers must show proof of income, so those who have been laid off or furloughed will not be eligible for a home equity loan or line of credit. Lenders will also typically refuse to provide home equity debt if your credit score is lower than the mid-600s. Many lenders raised the requirement to somewhere in the 700s during the coronavirus pandemic, and some temporarily stopped accepting applications in the early months of the crisis.
Step 3: Compare rates and fees
As with your first mortgage, it pays to shop around for rates, fees, and, especially with a HELOC, payback terms. Inquire about any fees that may apply, such as an application fee, an annual fee, and a cancellation or early closure fee. When it comes to HELOCs, it is critical to read the fine print and understand the seemingly minor details that can make a significant difference in how much you pay and when.
Are home equity loans and home equity lines of credit safe?
Keep in mind that obtaining a home equity loan or HELOC increases the amount of debt you have on your home. On these products, lenders typically take a second lien position, behind your first mortgage. If you are unable to pay, your home may be foreclosed on.
If the value of your home falls, so does your equity. Don’t borrow more than you can afford to repay (this also increases your odds of getting approved).
Taking a home equity loan vs. refinancing: Which is better?
An alternative to taking on a second mortgage is to refinance your first mortgage. If you simply want more cash in your monthly budget, you may be able to lower your monthly mortgage payment by refinancing at a lower mortgage rate.
If you need money now, you could opt for a cash-out refinance. With this type of refinancing, the cash you need is added to your loan balance, lowering the amount of equity you have in the home. Instead of adding a second home loan, a cash-out refinance replaces your current mortgage with a new one.
Borrowers with poor credit may be able to qualify for a cash-out refinance more easily than a HELOC or home equity loan. However, keep in mind that refinancing resets the clock on your mortgage, which means you will be paying for a longer period of time. With a cash-out refinance, you pay closing costs on the entire loan amount rather than just the amount you need.