What Is A Home Equity Loan And How Does It Work?

Get access to the money tied up in your home to pay off major expenses with lower interest rates.

Home equity is the value of your home that grows as you pay off the mortgage on it. It is the difference between the market value of your home and the mortgage that is still to be paid. If you have a major expense to be paid for, like a child’s education, your own student loan, your credit card debt, or any other debt, you can tap into and use the money tied up in the value of your home as equity. This is your complete guide for securing a home equity loan.

What Is A Home Equity Loan?

Home equity is the value of your home after paying off the debt. A home equity loan is a loan that you take out on the value of your home. It is generally classified as a second mortgage as it works just like that – it lets you borrow against the value of your home, while your home acts as the collateral for the loan. It is a paid as lump sum amount depending upon how much your house is worth, considering any outstanding loans that may exist on the house, like your first mortgage. As you pay off the first mortgage, your home equity increases.

What Is A Home Equity Line Of Credit?

A home equity line of credit or HELOC is also a type of a second mortgage. A HELOC is also taken out depending on your home’s equity, but unlike a home equity loan which is given as a lump sum payment to the borrower, a HELOC opens up a line of credit from where you can borrow whenever you need money. You can take as much or as little as you need up to a certain period of time, like 10 years, depending on how much you have available in your home’s equity. Like a credit card, you can repay and borrow again and again. The credit limit is fixed at the time when the loan is issued. You have to pay back the loan after you have withdrawn to the limit of the loan term or the limit of the loan amount. Your house acts as the collateral for the loan and the lender can foreclose it if you are unable to pay back the HELOC.

How Does Home Equity Loan Work?

A home equity loan works much like a first mortgage. You get a one-time, fixed amount of money from your lender and pay it back as monthly payments. Home equity loans have a fixed interest rate, so you know the exact amount you have to pay per month. Monthly payments include some part of the principal borrowed amount plus the fixed interest rate. Keep in mind that you will also have to pay the closing costs of the loan as well, like the origination fees, appraisal fees, recording fees, etc.

How Does A Home Equity Line Of Credit Work?

A home equity line of credit works much like a credit card. You borrow against the available equity in your home, while the house itself acts as the collateral. As you pay back the balance, the amount of equity available to you is restored, and you can borrow money again if you need to, like using a credit card. You can continue to borrow the money and keep restoring the balance again and again up to a certain time period, known as the draw period. after the draw period ends, you pay back any leftover dues in the repayment phase. The closing cost for a HELOC is lesser than that for a home equity loan, though the interest rate is a variable rate.

What Is Needed For A Home Equity Loan?

First and foremost, a home equity loan requires a lot of equity in your home. The more the equity, the better the rate you will receive from your lender. Every lender will have its own home equity loan requirements, but the basic conditions you need to meet are covered below:

1. 15 To 20 Percent Equity In Your Home
   The difference between the market value of your home and your mortgage is known as equity. Lenders will want you to have sufficient equity in your home that you can borrow the home equity loan against. They use what is known as the loan to value ratio or LTV to calculate how much equity you have in a home. To calculate the LTV, your lender will look at how much money you still owe in your first mortgage and divide that by the market value of your home. For instance, let’s say your house is valued at $450,000 on the market, and you still need to pay off $175,000 from your first mortgage. Your LTV ratio will then be 175,000/450,000 = 0.388 = 38.8 percent. This is the percentage of loans tied up to the total value of your house. The equity available to you is 100 – 38.8 = 61.2 percent. The equity available to you will help determine how much you can borrow as your home equity loan as well.
2. Credit Score Not Less Than 650
   After lenders make sure that you have enough equity to borrow from, they will look at your credit score to see if you will be able to pay back the loan or not. Most creditors require scores above 650, but some may allow lower scores as well with additional conditions. For instance, you may be able to borrow even with a lower score given that you have enough equity in your home and have a lower debt as compared to your income. Generally, the better the credit score, the more favorable are your chances of getting a loan, and the lower the interest rate you are offered.
3. Debt to Income Ratio of 43 Percent Or Lower
   As part of your home equity loan requirements, lenders will look at your DTI. The debt to income ratio is a measure for the lenders to be able to tell how you will manage to pay off the loan. The DTI ratio is an indication of how much of your gross monthly income from all sources combined is spent towards paying off all your monthly debts, from taxes to insurances, mortgages, direct liens, homeowners association dues, etc. The lower the DTI, the more manageable it is to pay off your loan. Most lenders will not accept a DTI above 43 percent, and some may want a lower figure. If your debt to income ratio is high, try paying some of the loans before you apply for a home equity loan. Alternatively, you might want to extend your existing loan terms, so your monthly installments are reduced.
4. A Steady Income
   A steady and sufficient income helps your debt to income ratio to be higher. The lender will ask to review proof of income, which can include your most recent W2 forms and your paycheck stubs for the past month from the loan application date. A self-employed individual will have to show federal income tax returns. If you are retired, you will have to show a retirement awards letter or a 401k distribution letter. Having supporting side incomes help to improve your odds of getting a loan at favorable terms.
5. Getting an Appraisal
   Another home equity loan requirement is getting an appraisal. Appraisals determine the market value of your home. This in turn is needed to calculate how much equity you have before you can take out a home equity loan. The lender will ask you to get an appraisal for your home or may have an independent appraiser take a look to get an estimate of how much your house is with on the market. The appraiser will look at anything that will bring down the value of your home, like pending repairs, health hazards, presence of termites or bugs, leaky roofs, etc. They will also look at things that will potentially increase the value of your home, like extra storage areas, added insulation, a new roof, etc. Keep in mind that you have to cover the costs for the appraisal. If you are not satisfied with the home value estimate by your appraiser, you can request a second one as well.

What Bank HasThe Best Home Equity Loan?

According to Bankrate, the average home equity loan rate stands at about percent. FOr a HELOC, it is even lower, at 4.52 percent. Below is a list of the banks with the best home loan rates for November 2020.

1. Discover
2. BMO Harris Bank
3. KeyBank
4. Spring EQ
5. Flagstar Bank
6.  U.S Bank
7. Frost
8. Regions Bank

It is best to compare rates before you take out a loan. Talk to your financial advisor or broker for more options.

Home Equity Loan Calculator

Doing your own research is important to prepare yourself before you get official rates from a broker or lender. You can use a home equity loan calculator online to do that.

1. Bank Of America – Home Equity Line of Credit (HELOC) Payment Calculator
2. Bankrate.com – Home Equity Loan Calculator
3. U.S Bank – Home Equity Loan Rates And HELOC Calculator

You will need to enter the amount you in debt on your home, the market value of our property, and the interest rate if you know that to get the best estimates.

Conclusion

Getting a home equity loan is one of the best ways to pay off a debt or to pay for a child’s education. With a lower interest rate, you can tap into your home’s equity and use it to pay for your expenses.