How Do Home Equity Loans Work?

Do you know how much equity you have in your home? One of the advantages of being a homeowner is having the ability to harness the equity you have built up in your home when you need cash. Perhaps you need to fund home improvements or want to consolidate your debt. Whatever the reason for leveraging your home’s equity, it’s important to understand how home equity loans work to see if it’s a good option for your financial situation. 

What Is a Home Equity Loan? 

Home equity loans are types of second mortgages that give you a lump sum of money at a fixed interest rate. Similar to a mortgage, the repayment terms can range from one to 30 years. Home equity loans often have lower interest rates than other financing options, making them useful for covering large expenses.

How Do Home Equity Loans Work?

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The amount you can borrow will vary based on how much equity you have in your home. Your equity is determined by the current market value of your home and the remaining balance on your mortgage. Generally speaking, you can borrow up to 85% of your home’s worth. For example, if your house is worth $500,000, then your loan amount can’t exceed $425,000. If you have a mortgage of $200,000, then the most you can borrow is $225,000. A great way to figure out how much you could borrow is to use an online calculator. There might be additional restrictions based on your maximum loan amount due to your credit score and debt-to-income ratio (DTI). 

Once the lender confirms the interest rate, amount, and repayment terms, they give you the entire lump sum of money. Typically, the lender deposits the money into your bank account, and you are free to use it how you wish.

What Is the Cost of Borrowing?

The cost of your home equity loan is determined by your interest rate, which is based on the federal funds rate as well as your credit score and other financial characteristics. In most cases, the interest that you pay on a home equity loan is less than what you could expect to pay on a personal loan. Interest rates on a home equity loan can generally range from 2.5% to 9.99%, depending on the length of your repayment terms.

The other thing to be aware of is that home equity loans often have closing costs. The costs vary based on the lender but generally range from 2% to 5%. Some lenders also let you roll the closing costs into your monthly payments. 

What Are the Drawbacks of a Home Equity Loan?

While there are many advantages to securing a home equity loan, you should also consider the drawbacks. A home equity loan uses your home as collateral. This means that, should you fall behind on payments, you may need to sell your home to free up the money to pay off the loan. In serious cases, you could lose your home. Another thing to consider is that you will now have additional monthly payments, which you’ll have to take into account when setting your budget.

What Are the Requirements for Securing a Home Equity Loan?

The qualifications that you need to meet to get a home equity loan depend on the lender. However, there are certain terms that most lenders look for: 

  • You should own at least 16% of the equity in your home, although more is ideal, as it will give you the opportunity to secure more funding.
  • Generally speaking, a lender will look for a credit score of at least 680 before considering you for a home equity loan. Your credit score will affect the rate you will be given, with a higher score generally meaning a more favorable rate.
  • You usually need a debt-to-income ratio of 43% or less to qualify for a home equity loan. Your DTI is calculated by dividing your monthly bill payments by your gross monthly income.

What Can I Do if I Have Bad Credit?

Having bad credit doesn’t mean you won’t be eligible for a home equity loan; however, it does make it much more difficult to secure one. Before trying to secure a home equity loan, you should check your credit report. Most home equity loans require a minimum credit score of 680, although some lenders will go as low as 620.

Next, gather as much of your financial information as you can to share with a potential lender. This includes income and any investments. You should also honestly consider how much cash you truly need. Since you’ll be paying interest on your loan’s entire principal, don’t borrow more than you need.

After that, you may still need a cosigner on your loan. Be sure you ask someone you can trust and who has a strong credit score as well as a stable income. This step comes with potential risks to you both, so everyone needs to be upfront about responsibilities and expectations.

You may also want to explore some alternatives with more flexible credit requirements, such as a Home Equity Investment (HEI). An HEI doesn’t require a monthly payment, and it’s more forgiving if you don’t have an ideal credit score or otherwise would have a hard time qualifying for traditional equity products.

How Can I Build Home Equity? 

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If you don’t have enough equity in your home to apply for a home equity loan quite yet, you can try a few equity-building strategies. The first is to keep making regular mortgage payments. If you are able to increase your mortgage payments, any additional money will go straight toward your principal, which will increase your equity. 

Home equity will also increase as the value of your home increases. Making improvements to your home may also help to increase its value and therefore the equity you have. However, it’s important to note that not all home improvements will add value, so be sure to consult your realtor before making any renovation plans. 

Are There Alternatives to a Home Equity Loan?

There are alternatives to a home equity loan if this form of borrowing isn’t a good fit for you. 

Home Equity Line of Credit 

A home equity line of credit (HELOC) is a great option if you are looking to borrow smaller amounts of money over a longer period of time. A HELOC is similar to a credit card, where you only have to pay interest on the money that you borrow. For example, if you were approved for a HELOC of $100,000 but you only took out $20,000, then you would only have to pay interest on the $20,000. If you were to take out an additional $20,000 from that same HELOC, you would then be paying interest on the full $40,000 borrowed. 

A HELOC is a revolving line of credit, so you can take out the money you need, pay it back, and take out more money if and when you need it again – up to a predetermined limit. Typically, there is also a minimum withdrawal amount. 

Cash-Out Refinance

A cash-out refinance is when you refinance the mortgage you currently have. This means you will sign a new contract with a lender to secure a larger amount of money than what was owed on your previous mortgage. This option makes sense if you are able to secure a lower interest rate than what you have on your current mortgage.

Home Equity Investment

Another way to get the funds that you need is with a home equity investment from Point. In exchange for a portion of your future home appreciation, you receive a lump sum of cash with no restrictions and no monthly payments. Instead, you repay the amount plus a percentage of your home’s appreciation through a home sale, refinance, or another source of funds at any time during the 30-year term. See if you qualify for a Point HEI today. 

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