A home equity loan is a second mortgage that allows you to borrow your equity, which is the difference between what your home is worth and what you owe on it. Home equity loans are a useful way to borrow money at a lower interest rate than other forms of consumer loans because they use your home as collateral.
How does a home equity loan work?
Home equity loans allow homeowners to borrow a lump-sum of cash that they pay back in fixed installments over a predetermined period. They usually are fixed-rate loans, so the interest rate remains the same throughout the term of the loan.
The amount you qualify for may be more money than you need or can afford. Review your household’s budget before agreeing to any terms. This way, you can ensure you can afford your monthly payments.
For example, say you can qualify for a $100,000 home equity loan, but the kitchen renovation you need to finance will cost $40,000. It’s best to limit the loan amount to your needs to avoid the larger payments on a bigger loan.
Another approach to ensure you can pay the loan back is choosing the best loan terms. You can choose anywhere between a 10- to 30-year loan term, depending on your goals for the loan. A 10-year term, while offering a quicker payoff, will have larger payments.
Pros and cons of home equity loans
Before you decide to get a home equity loan, you should be aware of the pros and cons. Consider your financial circumstances to determine whether the advantages outweigh the disadvantages.
Home equity loan pros
We’ll go over the pros of home equity loans first.
- They’re easier to qualify for than other types of loans.
- Interest rates are usually fixed and lower than for other consumer loans.
- The loan terms are longer than terms for other consumer loans.
- There are no restrictions on how you can use the funds.
Home equity loan cons
- There are also some drawbacks of home equity loans to consider.
- You’ll have a second mortgage to pay off.
- You risk foreclosure should you default on the loan.
- If you sell your home, you’ll have to pay off the entire balance of the loan – as well as the remaining balance of your primary mortgage.
- You’ll have to pay closing costs, unlike with some other consumer loans.
How to get a home equity loan
To get a home equity loan, you’ll need to qualify, which means your lender will calculate your equity and debt-to-income ratio, and pull your credit score. So, if you’re weak in one area, the other two can help boost your qualifications. Here is what each of these steps looks like:
1. Determine your equity with a home appraisal
To decide whether you qualify for a home equity loan and how much money you can borrow, your lender will have your home appraised. The home appraisal will tell the lender how much your home is worth, how much equity you have, and how much you can borrow.
For instance, Rocket Mortgage® will let you borrow up to 90% of your home’s value. To figure out the amount you could obtain through a home equity loan, you’d determine your loan-to-value ratio. To do this, subtract the remaining balance of your primary mortgage from 90% of the appraised value of your home.
For example, if your home is appraised at $400,000 and the remaining balance of your mortgage is $100,000, here’s how you’d calculate the potential home equity loan amount:
$400,000 x 0.9 (90%) = $360,000
$360,000 – $100,000 = $260,000
This means you could borrow up to $260,000 with a home equity loan.
2. Calculate your DTI ratio
Your lender will calculate your debt-to-income ratio, which shows how your monthly debt payments compare to your monthly income. This calculation helps lenders determine whether you can afford more debt.
Most lenders require a DTI ratio of 43% or less to qualify for a loan or mortgage. In some cases, a lender will require an even lower DTI ratio, and in others a bank might accept a higher DTI ratio depending on other factors, such as credit history and income stability.
You can figure out your DTI ratio using the following equation:
DTI = Total Monthly Debt Payments ∕ Gross Monthly Income
1. Add up all your monthly debt payments, including your primary mortgage, student loans, car loan, minimum credit card payment, alimony, and child support.
2. Divide the sum by your gross monthly income, which is the amount of money you earn each month before taxes and deductions.
3. Multiply the result by 100 to find the percentage.
For example, if your total monthly debt is $1,500 ($950 for your primary mortgage, $300 for your car loan, and $250 for credit card debt), and you earn $5,000 a month before taxes, your DTI would be 30%. In this scenario, your DTI would be low enough to qualify for a home equity loan.
3. Check your credit score
Your credit score plays a role in determining whether you qualify for a home equity loan. Individuals with higher credit scores often benefit from lower interest rates.
The minimum credit score needed for a home equity loan is generally around 620, but varies by lender. Some lenders might prefer your score be closer to 680. If you want a home equity loan, a higher credit score may allow you to access more of your equity.
At Rocket Mortgage, a 680 credit score means you can borrow up to 80% of your home equity. If your score is a median of 700 or better, you can access up to 85%. Finally, you can borrow up to 90% of your home’s value if your score is 740 or higher.
Remember that these LTV amounts combine both your primary mortgage and your home equity loan. For example, if you have 45% LTV on your primary mortgage, you can only borrow a further 45% of your home’s value for a total of 90%.