Building equity in your home is a significant financial achievement. Equity represents the portion of your home you truly own, calculated as your home’s current market value minus your outstanding mortgage balance. This equity grows as you pay down your mortgage and as your property’s value appreciates. Once you’ve built sufficient equity, you can leverage it to borrow money through a home equity loan or a home equity line of credit (HELOC). These options can be incredibly beneficial for financing home improvements, handling maintenance and repairs, or covering emergency expenses.
When you secure a home equity loan or HELOC, the bank places a lien on your home to secure the loan or line of credit, meaning your home acts as collateral. This guide will walk you through the process of obtaining a home equity loan, outlining its advantages, disadvantages, and how it compares to other financing options.
What is a Home Equity Loan?
A home equity loan is a type of lending product that allows homeowners to borrow against the equity they’ve accumulated in their homes. This equity is the difference between the house’s market value and the remaining mortgage balance. Home equity loans are often used to finance large expenses, such as home improvements, student loans, or to consolidate high-interest debt.
Interest rates for home equity loans are typically lower than those for personal loans or credit cards, making them a popular choice for funding significant projects or purchases. However, because your home serves as collateral, failing to make loan payments can result in the loss of your home through foreclosure.
How Does a Home Equity Loan Work?
Home equity loans function similarly to primary mortgages. Once you qualify based on your credit score, income, and the amount of equity in your home, the lender provides a lump sum of money. You are then obligated to repay this amount, along with interest, in fixed monthly payments over a predetermined period (the loan term).
The amount you can typically borrow is a percentage of your home’s appraised value, minus the outstanding balance of your primary mortgage. This calculation establishes the credit limit for your home equity loan. As you make payments, you’re paying down both the loan interest and the principal loan amount, unlike some interest-only payment structures. It’s crucial to carefully consider your ability to make these monthly payments before taking on a home equity loan due to the risk of foreclosure.
How to Get a Home Equity Loan: Step-by-Step Process
Your home can be a source of financial flexibility. Here’s a step-by-step guide to applying for a home equity loan:
Step 1: Decide How Much Cash You Need
Unlike a HELOC, which allows you to tap your equity as needed, a home equity loan requires you to borrow a specific loan amount upfront. Calculate exactly how much money you need before applying, as the amount you borrow directly affects the total cost.
As Dennis Shirshikov, a strategist at Awning.com and professor of economics and finance at City University of New York, advises, “Borrowing more than you need may sound tempting, but that directly affects your interest rate and total payment. Putting an extra $10,000 in the bank may seem like a good idea. [But] you will end up paying much more than that in combined principal and interest over the life of the loan.” Knowing your precise needs helps you avoid overpaying on interest and fees.
Step 2: Check Your Credit
Your credit score is critical. A score of 700 or above will generally secure a lower interest rate and better terms. The minimum score typically needed to qualify is 620.
You can check your credit score for free through your bank, credit card issuer, or by purchasing it directly from Experian, TransUnion, Equifax, or FICO for a more accurate number that lenders see. If your score is lower than desired, take steps to improve it before applying:
- Pay bills on time.
- Avoid opening new accounts.
- Pay balances in full rather than just the minimum.
- Correct any inaccuracies on your three free credit reports.
- Keep your credit utilization below 30% of your total limit.
Step 3: Compare Interest Rates and Lenders
When ready to apply, get quotes from multiple lenders and compare their offers. Rates and fees can vary significantly. Home equity loans are offered by banks, mortgage companies, credit unions, and online lenders.
Boyd Rudy, associate broker with Dwellings Michigan, suggests, “After you know how much equity you have, it’s time to start shopping for lenders. Compare rates and terms from several lenders before choosing one. Be sure to compare not only interest rates but also closing costs and fees.”
Step 4: Complete a Home Equity Loan Application
Once you’ve chosen a lender, formally apply for the loan. This can typically be done online, over the phone, or in person. The application process is similar to other mortgages; you’ll provide financial documentation like tax returns, bank statements, and proof of income. The lender will also likely order a home appraisal to determine your property’s current market value.
Step 5: Wait for Approval
After submitting your application, the lender’s underwriting team will review all your documents and complete a property valuation. “The lender will let you know of any next steps required during this time,” notes Shirshikov.
Step 6: Close and Receive Funds
Upon approval, you’ll receive a closing date and instructions. At closing, you’ll sign various documents and disclosures, and the funds will be deposited into your designated bank account, either via wire transfer or check.
How Long Does It Take to Get a Home Equity Loan?
The process usually takes up to four weeks or longer from application to receiving funds. This timeline depends on lender efficiency, appraisal time, and any issues that need addressing in your application.
“The largest variable is the time required for the property valuation,” explains Jason Scott, vice president and regional relationship banking manager at Sunrise Banks. “An electronic valuation can happen in as little as one day, but a full appraisal could take two to three weeks.” Ask lenders about their appraisal requirements and timelines when you shop around. Submitting all documentation promptly and responding quickly to lender inquiries can help expedite the process.
How Much Can I Borrow with a Home Equity Loan?
If you qualify, you can typically borrow up to 80% of your home’s value, minus any outstanding mortgage debt. This means you generally need more than 20% equity to get approval.
You can estimate your borrowing potential:
- Home value: $500,000
- Current mortgage balance: $250,000
- Maximum total borrowing amount (80% of home value): $400,000
- Maximum home equity loan amount: $400,000 – $250,000 = $150,000
“You can use survey sites [like] Zillow to get an idea of your home’s current value and accrued equity,” suggests Michael Hausam, a mortgage broker and Realtor, though he reminds that online estimates are not 100% accurate. Keep in mind that your specific loan amount also depends on your credit score and financial situation, and withdrawing more equity can sometimes lead to higher interest rates.
Home Equity Loan Requirements
To qualify for a home equity loan, you’ll need to satisfy several key requirements:
- Sufficient Home Equity: You need enough equity, typically measured by a loan-to-value (LTV) ratio or combined loan-to-value (CLTV) ratio of up to 85%. This means your existing mortgage balance plus the new home equity loan should not exceed 85% of your home’s value.
- Reasonable Debt-to-Income (DTI) Ratio: Lenders will assess your DTI, which is your monthly debt obligations divided by your gross monthly income. A lower DTI (ideally below 43%) makes you a more attractive borrower.
- Good Credit Score: A strong credit score (generally 620 or higher) demonstrates responsible credit management and a lower likelihood of default.
- Financial Documentation: Be prepared to provide recent pay stubs, tax returns, bank statements, proof of employment, and investment account statements. You may also need your most recent mortgage statement and proof of homeowner’s insurance.
- Money for Closing Costs: Expect to pay closing costs, which can range between 2% and 6% of the loan amount. These may include appraisal fees, loan origination fees, title search fees, and processing fees. While some lenders may roll these costs into the loan, this increases your total borrowed amount and potentially your interest rate.
Some lenders may have a “seasoning requirement,” meaning you might need to wait up to six months after buying or refinancing before applying. However, this isn’t universal, especially if you made a large down payment and have substantial equity.
Why Would a Home Equity Loan Be Denied?
Common reasons for denial include:
- Insufficient Equity: “The loan amount must be less than the value of your home. So if your home has decreased in value or your outstanding mortgage balance is high, the loan may be denied,” cautions Joshua Haley, founder of Moving Astute. If you recently bought your home with a small down payment, you might not have enough equity yet.
- Low Credit Score: Typically below 620.
- High Debt-to-Income Ratio: Usually above 43%.
- Negative Credit History: “You may also get denied if your credit history has multiple recent derogatory remarks,” says Shirshikov.
When Should You Get a Home Equity Loan?
A home equity loan is often an excellent choice when you need to borrow a large sum of cash. Since they are a type of mortgage, their interest rates are low compared to credit cards or personal loans. Another benefit is that they typically charge fixed interest rates, making your repayment schedule predictable.
Common scenarios where a home equity loan makes sense include:
- Paying for an expensive renovation or home improvement project.
- Paying down medical bills that are currently unaffordable out-of-pocket.
- Consolidating high-interest credit card debt at a lower, fixed rate.
- Financing a significant life event, such as an expensive wedding or your child’s college education.
However, there are scenarios where a HELOC might be a better fit due to its flexibility as a revolving line of credit, especially if your financial needs are ongoing or uncertain. It’s crucial to remember that your property serves as collateral, so if you cannot make payments, you risk foreclosure.
Home Equity Loan Rates
Home equity loan rates are a crucial factor. These rates often correlate with the prime rate, which commercial banks charge their most creditworthy customers. Home equity loan rates are typically higher than primary mortgage rates because lenders perceive them as riskier second liens.
The actual rate you receive depends on several factors, including your credit score, the loan-to-value ratio, and prevailing market conditions. While most home equity loans have fixed rates, some lenders may offer variable options, so it’s important to understand how different structures might impact your repayments. Always compare interest rates from multiple lenders to ensure you receive a competitive offer.
Pros and Cons of Home Equity Loans
Before deciding on the home equity loan process, carefully weigh the advantages and disadvantages, keeping your financial situation, repayment ability, and long-term goals in mind.
Advantages
- Significant Funding: Potential to secure a large amount of money for major expenses like renovations or debt consolidation.
- Predictable Repayment: Regular, fixed installments over a set period, similar to a traditional mortgage, making budgeting easier.
- Lower Interest Rates: Often come with lower interest rates compared to other types of consumer debt, such as credit cards.
- Potential Tax Deduction: Interest may be tax-deductible if the funds are used to buy, build, or substantially improve the home securing the loan (consult a tax professional).
Disadvantages
- Foreclosure Risk: Your home serves as collateral; inability to make payments could lead to foreclosure.
- Risk of Negative Equity: If your home’s value decreases, you could end up owing more than your property is worth.
- Closing Costs: You’ll incur closing costs and origination fees, adding to the overall cost of the loan.
- Increased Debt Load: Taking out a home equity loan increases your overall debt, potentially impacting your ability to borrow in the future.
Alternatives to Home Equity Loans
While home equity loans are beneficial for financing big-ticket items, they aren’t the only option. Consider these alternatives based on your personal finance goals, credit situation, and home equity:
- Home Equity Line of Credit (HELOC): A popular alternative that provides a revolving line of credit you can draw from as needed during a “draw period.” HELOC rates are typically variable.
- Cash-Out Refinance: Replacing your existing mortgage with a new, larger loan, giving you the difference in cash. The new loan replaces your old one, and its interest is often tax-deductible.
- Personal Loans: Don’t require your home as collateral and offer quick access to funds. However, they generally come with higher interest rates and lower borrowing limits.
- 0% APR Credit Cards: Suitable for smaller expenses, offering an introductory period with no interest. You must pay off the balance before the promotional period ends to avoid high interest.
- Certificate of Deposit (CD) Loans: If you have money in a CD, you can borrow against it. These loans often have lower interest rates and don’t require a hard credit inquiry.
Each alternative has unique advantages and risks. Understanding the loan terms, your property’s appraised value, interest rates, and your personal finance goals are crucial. Always consider consulting a financial advisor or mortgage professional to discuss which loan product best suits your needs.
FAQ: How to Get a Home Equity Loan
How soon can you get a home equity loan after buying a house?
Some lenders have a “seasoning requirement” (e.g., waiting 6 months), but not all. If you made a significant down payment and have substantial equity, you might qualify sooner.
What is the process of getting a home equity loan?
It involves deciding on your loan amount, checking your credit, comparing lenders, completing an application with financial documents, waiting for approval (including an appraisal), and finally, closing and receiving funds.
Does a home equity loan require a credit check?
Yes, a credit check is a standard part of the application process to assess your creditworthiness.
How to get a home equity loan with bad credit?
While challenging, it’s possible if you have substantial home equity and a low debt-to-income ratio. However, expect a higher interest rate. Focus on improving your credit score before applying.
Does a home equity loan require an appraisal?
Yes, most lenders require a professional home appraisal to determine your property’s current market value and, consequently, the amount of equity you have to borrow against.
Your Next Steps to Getting a Home Equity Loan
Now that you understand the home equity loan process, remember it’s not your only option for accessing extra money. As you explore how to apply, compare the benefits, interest rates, and terms with other financing options, such as a HELOC or cash-out refinance.
As Scott recommends, “Also, remember that your home is your largest asset. As such, you should always plan for how the debts you have against your home will be repaid.”
If you’re ready to move forward, start by checking out the best home equity loan rates from a few different lenders to find the most affordable option.