Home equity is the biggest financial asset for the typical American homeowner. Although it’s not a liquid asset, your home can be a source of funds when you need it. Using your home’s equity to pay off high-interest loans or finance a renovation project is a major financial decision. Learn more about home equity loans to determine if this is the right option for you.
What Is Home Equity?
Home equity represents your home’s appraised value minus outstanding balances, such as your mortgage or loan. You build up home equity when you make mortgage payments and the home’s value increases over time due to home appreciation.
Home equity is a valuable asset you can leverage to get a home equity loan or a home equity line of credit (HELOC). Here are the differences between these two options:
- Home equity loan: A home equity loan is a fixed amount of money that typically comes as a lump sum of cash. It’s also sometimes referred to as a second mortgage. You can use the money for a one-time expense, such as home renovations or consolidating debt on higher-interest balances. The loan usually comes with a fixed rate, so you know exactly how much your monthly payment will be.
- Home equity line of credit (HELOC): A HELOC offers a variable interest rate on a revolving line of credit of your home equity funds. Banks typically offer various ways to obtain this money, whether you receive it through an online transfer, credit card connected to your account, or a check.
With either option, lenders examine your debt-to-income ratio (DTI) to compare the amount of debt you have to your overall income. It’s used to measure your ability to manage monthly payments and repay the amount you borrowed.
How Do I Get a Home Equity Loan?
Obtaining a home equity loan can be a smart decision. However, before you start thinking about what home renovation projects you plan to tackle or what credit cards to pay off, it’s important to know what lenders need for approval. The specific qualifications for a home equity loan vary by lender, but most require you to meet the following qualifications:
- Have at least 15% to 20% equity in your home.
- Possess a credit score of 620 or greater.
- Have a DTI ratio of 43% or lower.
Once you make sure you meet these three qualifications, you can choose a lender and later schedule your home appraisal, which will help determine the exact value of your home – an important part of calculating how much equity you have.
How Do I Calculate the Equity for a Home Loan?
To determine how much you can borrow for a home equity loan, you’ll first need to know how much equity you have available.
Calculating Loan-to-Value Ratio
One of the ways that lenders determine if you qualify for a loan is to examine your loan-to-value ratio (LTV). To determine what your LTV is, follow these steps:
- Take your home’s remaining mortgage and divide it by your home’s appraised value.
- Take the result of the previous step, and multiply it by 100 to convert it to a percentage to find your LTV.
Example: Your home is worth $350,000, and your mortgage is $200,000. Here’s the breakdown:
$200,000 / $350,000 = 0.57
0.57 x 100 = 57%
Calculating Combined Loan-to-Value Ratio
To determine how much money you can borrow with a home equity loan, lenders also review your combined loan-to-value (CLTV) ratio. Your CLTV ratio is your LTV after receiving your home equity loan.
Most lenders require a CLTV to be less than 85%.
Follow these steps to calculate your CLTV:
- Add the current mortgage and your desired loan amount.
- Divide the previous step’s number by your home’s appraised value.
- Take the answer and multiply it by 100. This number is your CLTV.
Example: You want to take out a loan for $25,000, you need to calculate. Here’s the breakdown:
($200,000 + $25,000) / $350,000 = 0.64
0.64 x 100 = 64%
What Are Some Advantages of a Home Equity Loan?
Using a home equity loan to get funds has several benefits, including:
- It allows for predictable repayment costs. You know exactly how much you’re paying back each month since the payment amount never fluctuates. It acts like a second mortgage, and you make payments just like you would on your original first mortgage.
- You can secure a low interest rate. Typically, home equity loans have lower interest rates compared to credit cards or personal loans. Therefore, choosing a home equity loan may be a more effective financial option.
- You can keep your mortgage. If you locked in your mortgage at a low interest rate, you don’t need to refinance, so you won’t risk losing that low rate.
- You can declare the interest in some cases. According to the IRS, you can claim a tax deduction if you use the money to build, buy, or improve your home.
What Are Some Disadvantages of a Home Equity Loan?
Just as there are benefits to securing a home equity loan, there are downsides as well, including:
- You have an additional monthly payment. These payments can be rather expensive and might not work with your budget.
- You lose equity in the home. When you take out a loan, your equity shrinks while your financed loans increase.
- You risk going underwater. If the real estate market takes a hit and your CLTV ratio is high, you run the risk of going underwater on your loan. This means that the mortgage is larger than what the house is worth, which might make it impossible for you to sell. If you want to sell your home and it’s underwater, you must have the cash on hand to make up the difference between how much you owe and what the house is worth.
- You could lose your home. Borrowing on equity is risky as you’re using your house for collateral, and failing to make timely payments could end up costing you your home.
While a home equity loan is a traditional method for financing a renovation or paying down debt, we offer an alternative through our Home Equity Investment (HEI) at Point. With HEI, you can get up to $350,000, with no monthly payments. You can pay back any time within the flexible 30-year term. We offer no prepayment penalty, and you can repay via the home’s sale or a cash-out refinance. Point also helps homeowners who might not qualify for traditional products such as home equity loans. Contact us today to learn how an HEI can help you.Tags: Home Equity