What is a Home Equity Loan?
With a home equity loan—often known as a “second mortgage”—the borrower receives a one-off payment from the lender, and the size of the equity goes down relative to the size of the loan. When you receive an equity loan, your terms will include additional interest and fees, and as you repay the loan, your equity will increase.
A home equity line of credit (HELOC), is a line of credit taken out against your equity, but you only have to pay back what you use from the credit line.
How Does a Home Equity Loan Work?
Applying for a home equity loan is similar to applying for a mortgage and if you have equity on your property, you can potentially receive one. If you’re applying for a home equity loan, you’ll need to provide much of the same information and documents as you would for a standard mortgage. This includes things like your credit score, proof of income, and outstanding debts.
The lender will also want you to have your home professionally appraised, in order to get a clear idea of what the home is worth and how much equity you have on your original mortgage.
Different lenders have different limits on how much they’ll let you borrow against your equity, with some allowing you to borrow up to 80%-90%. The lenders do this by looking at the combined loan to value ratio, which looks at how much you owe on your first mortgage and the HEL as a percentage of your home’s appraised value.
If the loan is being used to renovate our home, the interest you pay to the lender is tax-deductible. This is not the case if you are using the equity loan for expenses that aren’t related to the home.
Why Get a Home Equity Loan
The question remains, what are the benefits of taking out a home equity loan?
With a home equity loan, you can borrow money against the equity you have built up in your home. This can be a great way to consolidate debt—such as high-interest credit card debt—in that home equity loans tend to have lower interest rates. These are typically around 5%, while the average credit card interest rate is typically around 15%.
Another effective use of a home equity loan is to make home renovations. Not only can these be tax exempt, but using the loan for renovations is a solid way to quickly improve the value of the property ahead of a sale.
Simply put, home equity loans are a quick and easy way to get cash and consolidate debt, assuming you have the equity needed.
| Pros | Cons |
|---|---|
| Lower interest than other loans | You have to put your home up as collateral |
| Flexible, use it how you please | Closing costs and fees can be pricey |
| Solid way to consolidate debt | You are taking on additional debt |
How to Choose the Right Home Equity Lender
Your first step in deciding which home equity lender to go with is to figure out what you need. What is the amount of money you need to take out, what are the average interest rates given by the company, and will you be able to make the payments in time, month after month?
Look at the credit score requirements of the company and see how you match up. If your credit isn’t high enough you might not get approved at all, or only for a loan with terms that aren’t so friendly.
It’s helpful to find a company that has an easy application process and which will provide you with personalized customer service throughout the process. Ideally the company will also send you multiple loan offers with different terms, so you can decide the one that’s right for you.
In addition, not all lenders charge fees for the loan. You can easily find ones that don’t charge an application fee or origination fee, and don’t charge you any sort of closing costs. While these fees aren’t as big a burden as the loan itself, they can still take a bite, so shop wisely and you should be able to find a company with no fees.
The Costs of Home Equity Loans
One of the drawbacks of home equity loans is that you have to put your house up as collateral (you’re borrowing against the equity) and that does bear some risk. In addition, a number of lenders charge a flat origination fee which can be anywhere around $50 or into the hundreds of dollars or more. More significantly, many lenders charge a closing fee as part of the loan which can be as much as 2%-5% of the loan value.
Home Equity Loans VS Lines of Credit
With both home equity loans and home equity lines of credit (HELOC), you are borrowing against the equity in your home in order to get some cash flow. Both are a way for you to get some of your real estate gains—which are at the moment on paper—and use them in your daily life, for debt consolidation or for expenses that you just don’t have the cash for at the moment.
With a home equity loan, you receive the money as a lump sum that you then pay back as part of a fixed term mortgage. With HELOC, you receive the funds as a credit line that you can use when needed and you only pay interest on the money you use on the credit line.
One of the drawbacks of a home equity loan is that you’ve taken out the money in a lump sum, which could work to your disadvantage if the value of your property drops for some reason.
On the other hand, you’ll have the benefit of a fixed interest rate and monthly payments. On a HELOC, the interest rates may be variable, which can work to your favor while also being unpredictable at times.
| Type of Loan | Ideal For |
|---|---|
| Home equity | Debt consolidation, taking out a large amount of money with fixed rates and payments |
| Home equity line of credit (HELOC) | Getting cash flow that you may not need all at once, only when needed. More flexible, less risk |
Home Equity VS Refinance
With a cash-out refinancing loan, you take out a new mortgage that is larger than your remaining loan on the original mortgage, and you take the difference in cash. Ideally this new mortgage will be with interest rates that are lower than the original loan, and the cash influx can easily be used to pay off other, higher interest rates.
With a home equity loan, you aren’t taking out a new mortgage on the entire property, rather, you are borrowing a set amount of your overall equity, and then paying that back as a loan that is separate from your mortgage.
A cash-out refinance is better for not only getting some cash flow, but also for securing a new mortgage with better rates.
No matter what you need the money for—home renovations, medical treatment, or just a family vacation that you don’t quite have the money for—home equity loans, HELOC, and cash-out refinancing can help you get the cash flow you need, and hopefully loan terms that are better than what you’re dealing with. It’s just one way to get a better handle on your finances, and a little relief.