As a homeowner, understanding financial products like home equity loans and home equity agreements (HEAs) is crucial because they offer effective ways to leverage the equity you’ve built in your home to achieve various financial goals. This can include financing home renovations, paying off high-interest debt, or funding your children’s education.
Key Takeaways
- Home Equity Loan (HEL): You borrow against your home’s equity, receiving a lump sum upfront. This is repaid in equal monthly installments with a fixed interest rate over a set term.
- Home Equity Line of Credit (HELOC): You also borrow against your home’s equity, but you get a revolving line of credit that you can access as needed. Repayment occurs over a set term, but typically with variable interest rates, meaning your monthly payments can change.
- Collateral Risk: Since your home serves as collateral for both HELs and HELOCs, you risk losing your home to foreclosure if you fail to make your payments.
- Preparation is Key: To secure optimal terms and prevent foreclosure, it’s essential to compare different providers and build a strong credit history before applying.
- Non-Debt Alternatives: If you need cash but don’t qualify for or prefer not to take on a loan, non-debt products like Home Equity Agreements (HEAs) are an alternative.
What is a Home Equity Loan?
A home equity loan (HEL) allows you to borrow money against the equity in your home. The lender provides a lump sum upfront, which you then repay in equal monthly installments at a fixed interest rate over a set term (usually 5 to 15 years). Your home serves as collateral for the loan.
Who Qualifies for a Home Equity Loan?
While eligibility criteria vary by lender, common minimum requirements include:
- Credit score: 620 or higher (some lenders may require 680+ for better rates).
- Debt-to-income (DTI) ratio: 43% or lower (some lenders may accept up to 50%).
- Loan-to-value (LTV) ratio: 85% or lower, meaning you need at least 15-20% home equity.
How Much Can You Borrow?
You can typically borrow no more than 85% of the total home value (which includes your primary mortgage). Lenders determine the exact loan amount based on:
- Your income
- Your credit score and payment history
- The amount of equity you have in the property
- The current market value of your home (often determined by an appraisal)
- How much you owe on your home, including any other home equity loans, primary and second mortgages, HELOCs, and other liens.
Where Can You Get a Home Equity Loan?
You can obtain a home equity loan from various financial institutions, including:
- Banks
- Credit unions
- Mortgage companies
- Savings and loan associations
How Much Does It Cost to Get a Home Equity Loan?
Interest rates vary, so shopping around is crucial. In addition to the interest rate, be mindful of various fees, which may appear as separate charges, interest rate add-ons, or “points”:
- Broker fees
- Appraisal fees (typically $300-$800)
- Application or loan processing fees
- Origination or underwriting fees (often 0.5% – 1% of the loan amount)
- Lender or funding fees
- Document preparation and recording fees (county recording fees can average around $125, title search $75-$200)
- Title fees (for title search and possibly title insurance)
- Discount points (paying upfront to lower interest rate; 1 point = 1% of loan amount)
What Happens if You Don’t Repay Your Home Equity Loan?
If you default on your payments, your lender can initiate foreclosure, a legal process to take ownership of your home and sell it to recover the amount due. Lenders typically don’t foreclose immediately; you’d usually need to miss several monthly payments. If you have insufficient equity or are “underwater” (owe more than the property is worth), lenders might be less likely to foreclose and may instead sue you for the money, repossess other properties, or levy your bank accounts, all of which can severely damage your credit score.
Can You Cancel a Home Equity Loan?
Under federal law, you generally have three business days to cancel a signed home equity loan agreement without penalty, provided the property is your principal residence. There are exceptions, so it’s always best to discuss this with a financial advisor beforehand.
Home Equity Lines of Credit (HELOCs)
HELOCs are similar to home equity loans in that they allow you to borrow against your home’s equity, and you face the risk of foreclosure if you default.
However, HELOCs differ in key ways:
- Rolling Line of Credit: Instead of a lump sum, you get a flexible credit line you can tap into as needed, which is ideal if you’re unsure of the exact amount or timing of funds required.
- Adjustable Interest Rates: Most HELOCs have variable interest rates, meaning your interest rate and, consequently, your monthly payments, can change and potentially increase over time.
- Lower Upfront Costs: Compared to home equity loans, HELOCs often have lower signing costs, or sometimes none.
To qualify for a HELOC, you typically need similar criteria:
- Credit score of 620 or above
- LTV ratio of 85% or lower
- DTI ratio of 43% or lower
Home Equity Agreements (HEAs)
Home Equity Agreements are a distinct financial option because they are not loans. This means:
- No monthly payments.
- No interest rates.
- No income requirements.
Instead, an HEA provider gives you a lump sum of money upfront in exchange for a share of the proceeds when you sell the property after the end of a specified term (usually 10 years). You retain full ownership and continue to live in your home. If you wish to stay in your home beyond the term, you can buy out the HEA provider’s share.
To qualify for an HEA, you typically need:
- Credit score of 500 or above
- LTV ratio of 80% or lower
Mortgages vs. Home Equity Loans/HELOCs
All three (mortgages, HELs, HELOCs) use your home as collateral. The primary distinction is their purpose:
- Mortgage: Enables you to purchase a home initially.
- Home Equity Loan/HELOC: You can only take these out after buying a property and building sufficient equity (typically at least 15-20%).
Reverse Mortgages
Similar to home equity loans, reverse mortgages allow you to borrow against your home’s equity, with funds received as a lump sum, monthly payments, or a credit line. However, reverse mortgages have specific eligibility:
- You must be 62 years or older (or 55+ for some products).
- You must own your home outright or have substantial equity (usually 50%).
- Crucially, you don’t make repayments. The debt becomes due only when you die, sell the property, or move out for more than a year.
How to Shop for HELs and HELOCs
To secure the most cost-effective home equity loan or HELOC:
- Check Your Credit Reports: Lenders assess your creditworthiness via your credit score and existing debt. Access your free annual reports from Equifax, Experian, and TransUnion via AnnualCreditReport.com and correct any errors promptly.
- Improve Your Credit Score: Even if you meet minimum requirements, a higher score can lead to better terms. Focus on:
- Paying all bills on time: This is a major factor in your score.
- Paying off debt early: Especially high-interest credit cards.
- Not closing credit card accounts: This impacts your credit utilization and history length.
- Keeping credit utilization low: Aim for balances well below your credit limits.
- Avoiding opening multiple credit accounts simultaneously: New applications temporarily lower your score.
- Using a budget: To ensure you can meet monthly payments.
- Protecting personal information: Guard against identity theft that could open fraudulent accounts.
- Calculate Your LTV: Your loan-to-value ratio shows the relationship between your loan amount and your home’s appraised value. Lenders consider an LTV over 80% as higher risk, potentially leading to higher interest rates. Divide the total loan amount by your home’s appraised value and express as a percentage.
- Compare Different Providers: Start with your current bank or credit union, as they might offer loyalty discounts. Then, research and compare offers from at least three different lenders. Look beyond just interest rates; consider fees, annual percentage rates (APRs), and any special promotions.
Things to Watch Out For
Be aware of deceptive or unlawful practices from unscrupulous lenders, particularly if you are an older or financially distressed homeowner:
- Loan flipping: Repeatedly refinancing a loan, adding fees and increasing debt each time.
- Bait and switch: Offering favorable terms initially, then pressuring you to accept higher fees at closing.
- Insurance packing: Adding unnecessary insurance products to your loan.
- Equity stripping: Approving a loan solely based on your home’s equity, without assessing your ability to repay, aiming for foreclosure.
- Non-traditional loans: Offering products that aren’t standard HELs or HELOCs, such as those with minimum payments that don’t cover principal and interest, or low monthly installments with a large balloon payment at the end.
Is a Home Equity Loan or Home Equity Line of Credit Right for You?
A home equity loan or HELOC can be a good choice if you have sufficient equity, need cash, and can comfortably afford the payments.
- Choose a HELOC if you’re unsure how much cash you’ll need or when you’ll need it, due to its flexibility.
- Choose a Home Equity Loan if you need a specific lump sum for a defined, one-time expense and prefer predictable, fixed monthly payments.
If you need a lump sum but don’t meet HEL/HELOC eligibility criteria, or prefer not to take on debt, a home equity agreement might be a suitable alternative. Companies like Unlock specialize in equity-based HEAs as a non-debt solution.