Home equity is the amount of ownership you hold in your property. As long as your mortgage balance is smaller than the property value, you have some amount of home equity. Lenders allow you to borrow against a portion of that ownership in the form of a home equity loan.
Learn more about home equity and whether borrowing against your house is the right move for you.
How does a home equity loan work?
A home equity loan lets you borrow up to a certain percentage of your equity. It’s usually structured as a fixed rate loan with monthly payments over a predetermined period of time. Payments include both principal and interest and are usually amortized so that you pay more interest at the beginning of the loan term.
“This kind of loan is a secured loan, meaning there is collateral that guarantees that the lender has something to collect if you don’t make payments,” Gates Little, CEO of altLine at the Southern Bank Company, said. In other words, your home is used as collateral and could go into foreclosure if you default on your home equity loan.
Related: Learn more about refinancing your mortgage on Credible.com
How does equity build?
Equity builds in a few ways:
- A large down payment: When you first buy your home, making a larger down payment significantly increases your equity.
- Paying your mortgage: When you make a mortgage payment, you’re paying down your balance while also increasing your home equity.
- Property value rises: When your property value rises (also called appreciation) your equity increases. The value of your property depends on the state of the economy and your location. Additionally, if you make any additions to your home, including improvements or repairs, this can add to the value of your property.
Average rates for a home equity loan
Most (but not all) home equity loans come with a fixed interest rate. This is an advantage, according to Little: “A fixed rate ensures that your monthly payments are predictable.”
Additionally, home equity loans tend to have lower rates than many other options because the property itself is used as collateral. When looking for the best home equity loan rates, the starting range can vary between 5.570% APR and 8.500% APR, depending on the lender and your credit profile.
Good to know: Another important benefit of some home equity loans is that the interest may be tax deductible. In order to take advantage, though, you’ll need to meet two requirements:
- Itemize your tax deductions
- Loan funds are used to buy, build, or improve the property that is used as collateral
Costs and fees
One of the drawbacks of a home equity loan is that it comes with higher closing costs than other types of financing. It’s important to weigh the full cost of your loan options before making a decision.
“Home equity loans come with fees and closing costs that could make them less of a ‘deal’ than other financing options, depending on your financial situation,” Little said. “If you have to pay more interest for a personal loan but don’t have to use your home as collateral or pay closing fees, it may be a better deal than the home equity loan.”
What kind of closing costs can you expect with a home equity loan? Here are common fees:
- Appraisal fee
- Lender origination fee
- Credit report fee
- Title search
- Notary fee
It’s important to compare these costs in addition to your interest rate.
How do you qualify?
There are a number of factors that lenders examine during the home equity loan application process.
“Excellent credit scores, proof of reliable employment and even down payments are becoming more important when securing a home equity loan,” Little said. “Prepare to have these elements of your financial picture scrutinized closely.”
Let’s take a look at the three primary application factors.
Credit score
It’s certainly possible to get a home equity loan with bad credit, but you may need to search for specific lenders who work with this type of credit profile. And it may be harder to qualify while there’s a sense of economic turbulence.
“Due to the growing uncertainty in the housing market, lenders are more cautious about approving these types of loans. They are also paying close attention to credit scores (at least 700 is preferred by most lenders),” said Michael Branson, CEO of All Reverse Mortgage.
Debt-to-income ratio
Even with an excellent credit score, you’ll need to have the income to support home equity loan payments without too much debt from other sources. “Lenders are looking for a maximum of 43%. This means that your monthly debt expenses should not exceed 43% of your gross monthly income,” Branson said. “Some lenders are even going as low as 36% for debt-to-income ratio, taking note of the current environment.”
Total equity
Lenders limit how much of your equity you can borrow against. In most cases, you can only borrow up to 85% of your property value, which includes your mortgage.
How to determine your home equity
Let’s take a look at how to calculate your home equity and how much you can potentially borrow.
The first piece of information you’ll need is your property’s current market value. Real estate websites can help you get a sense of this number, although ultimately a lender may require an appraisal to confirm.
Then you’ll need to know your mortgage balance, since you can typically borrow up to 85% of your home value. Multiply the property value by 0.85 to determine your maximum loan-to-value ratio. Then subtract your mortgage balance — that leftover number is the amount you can borrow for a home equity loan.
Here’s an example:
Say your home is valued at $400,000. Your remaining mortgage balance is $275,000. Start by finding the maximum loan-to-value (LTV):
$400,000 x 0.85 = $340,000 (maximum LTV)
Next, subtract your LTV by your outstanding mortgage:
$340,000 – $275,000 = $65,000
That means you can apply to borrow up to $65,000.
Home equity loan pros and cons
Before you start filling out home equity loan applications, weigh the pros and cons.
Pros:
- Lower interest rates than other types of financing
- Loan interest may be tax deductible in some scenarios
- Monthly payments are usually fixed (and therefore predictable)
- Funds can be used for almost anything
Cons:
- Risk of foreclosure if you default
- Higher closing costs compared to some other options
- May spend more than you need
How to apply for a home equity loan
If a home equity loan sounds like the right choice, here’s how to apply:
- Get prequalified from multiple lenders to compare costs.
- Choose a lender and fill out a formal application.
- Submit required documentation, such as bank statements, pay stubs, and current mortgage balance.
- Undergo the home valuation process, which may include a professional appraisal and title search to confirm home ownership.
- If approved, receive your home equity loan as a lump sum.
Alternative options for home equity loans
Besides home equity loans, you have other options to buy a home:
- Home equity lines of credit (HELOCs): This option works much like a credit card, allowing you to take out funds up to your credit limit during the initial draw period.
- Reverse mortgage: If you’re 62 years of age or older, you can receive funds from a lender by borrowing against the equity in your home. You can use the funds for home improvements, repairs, or living expenses.
- Cash-out refinance: With a cash-out refinance, you replace your current mortgage with another loan, withdrawn as cash. Over time, you pay back the loan and your home still acts as collateral. The cash can be used for any purpose.
Related: Learn more about refinancing your mortgage on Credible.com
Personal loans and credit cards
While it’s possible to use a personal loan for a mortgage, it’s generally not advisable. Personal loans have shorter repayment periods and higher interest rates, so a mortgage is a better option to buy a home. Similarly, credit cards carry higher interest rates and fees. You shouldn’t use one to buy a home or to make a down payment.
Compare these options with a home equity loan:
| Home equity loan | Home equity line of credit (HELOC) | Cash-out refinance | Reverse mortgage | Personal loan | Credit cards | |
|---|---|---|---|---|---|---|
| Collateral required? | Yes (property) | Yes (property) | Yes (property) | Yes (property) | Depends (often unsecured) | Depends (often unsecured) |
| Upfront fees | Closing costs | Closing costs, May have annual fee |
Closing costs | Closing costs, Mortgage insurance premium |
May have lender origination fee | None |
| Term length | 5 to 30 years | 10-year draw period 20-year repayment period |
10 to 30 years | No set term length | 1 to 5 years | Revolving credit; doesn’t come with fixed term |
| Type of funding | Lump sum | Credit line draws | Lump sum | Lump sum | Lump sum | Credit line |
Frequently asked questions
Can I get a home equity loan with bad credit?
Lenders typically prefer a FICO credit score of 680 or more to qualify for a home equity loan, but that doesn’t mean you can’t improve your credit score in order to qualify. Your loan-to-value ratio should also be at least 80%, with at least 20% equity in your home. You should also have a debt-to-income ratio of 43% or less. It may be possible to get a loan with a score below 680, but be prepared for a lower loan amount and higher interest rate.
Should I take out a home equity loan?
It depends on your financial situation. It could be a good choice if you’re confident in making your payments on time and you have a clear purpose for the loan funds. But if you’re prone to late payments and overspending, or you’re already stressed about making your mortgage payments, it’s probably not the best choice.