Financial Security

What Is a Home Equity Loan?

Written by EveryIncome | 3/28/22 9:20 PM

If you own a home and have paid your mortgage down a bit, you may have some equity in your home. Equity is the difference between your home’s value and the outstanding mortgage. In other words, it’s your investment in the property. 

At first glance, it may feel like your equity is tied up in your home since homes aren’t liquid. You probably think you have to move to get the difference between your home’s value and your mortgage. But there are ways to get your equity out while allowing you to stay in the home. 

Here’s what you must know.

What is a Home Equity Loan? 

A home equity loan, as the name suggests is a loan that allows you to borrow against the investment you’ve built up in your home. 

Most lenders allow you to borrow up to 80% of a home’s value minus any outstanding mortgages you already have. For example, if your home is worth $250,000 and you have a $100,000 mortgage outstanding, you can take out a second mortgage for as much as $100,000 and still be at 80% of the home’s value. 

There are different types of home equity loans you can take out, though. Understanding how each one works can help you decide which is right for you. 

Home Equity Loan 

The home equity loan is a standard second mortgage. It has a fixed rate and term, and you receive your funds in one lump sum.  

Using our example above, you’d receive $100,000 at the closing to use as you wanted. You would then owe principal and interest payments over the life of the loan, which is usually 20 years. As you pay the principal balance down, you’d earn the equity back in the home that you borrowed. 

The funds you receive with a home equity loan are for one-time use. You cannot redraw the funds once you use them – it’s a one-time disbursement. 

Home Equity Line of Credit 

A home equity line of credit is another second mortgage on the home, but it works differently. Unlike the home equity loan, it doesn’t have a fixed rate and term. HELOCs have a variable interest rate that changes monthly. 

Like home equity loans, you can borrow up to 80% of the home’s value minus any outstanding mortgages you already have on the home. But how you receive the funds is different. 

A HELOC is a credit line, much like a credit card. You have access to the full line, but you don’t have to withdraw the funds if you don’t need them. The funds can sit in the credit line unused, or you can draw them. 

When you draw funds from the line, you use them as you want. You’ll only owe interest on the amount you withdraw, not the entire line. You also aren’t obligated to pay the principal right away. It’s like the minimum payment on a credit card. You can make the minimum payment or pay more to pay your balance down. 

The draw period on a HELOC lasts for 10 years. During that time, you can withdraw funds, use them, pay them back and withdraw them again. After 10 years, you go into the repayment period which is a 20-year term and requires both principal and interest payments. 

Cash-Out Refinance 

The final option to tap into your home’s equity is to take out a cash-out refinance. This is a refinance of your first mortgage; it’s not a second mortgage. 

A cash-out refinance works much like a second mortgage though. You can borrow up to 80% of the home’s value, but instead of taking out two mortgages, you have one. You will pay off your existing first mortgage with the proceeds and the difference between the loan amount and your mortgage payoff is yours. 

A cash-out refinance can be a conventional, FHA, or VA loan. You can choose from a variety of terms ranging from 15 – 30 years and have a fixed or variable interest rate. You make payments right away including both principal and interest and receive the funds in one lump sum to use as you need. 

How to Qualify to Use your Home’s Equity  

Qualifying to use your home’s equity is much like qualifying for your first mortgage. You must prove you have good enough credit, a decent debt-to-income ratio, stable employment, and any necessary reserves. 

Each loan program is different, but here are some common requirements: 

  • 640+ credit score 
  • A debt ratio of 50% or less 
  • Stable income for the last 2 years 
  • Enough assets to cover the closing costs 
  • No recent bankruptcies or foreclosures 

To prove you’re eligible, you’ll provide the following: 

  • Paystubs covering the last month of employment 
  • Tax returns for the last 2 years if you’re self-employed 
  • W-2s for the last 2 years if you aren’t self-employed 
  • Bank statements for the last 2 months 
  • Recent mortgage statement to prove your payment history 
  • Approval to pull your credit 
  • Letters of explanation for any negative credit, employment gaps, or any other unique situations 

Reasons to Use a Home Equity Loan 

Whether you take out a home equity loan, HELOC or cash-out refinance, here are some common reasons homeowners use them. 

Home Renovations 

Home renovations are the best use of your home’s equity because you reinvest in your property. You take the money out of your equity, but use it to increase your home’s value, which increases your equity. 

A HELOC is often best for home renovations because it offers a revolving credit line should you come across expenses you weren’t expecting or decide you want to do more once you start.  

You don’t have to do major renovations to increase your home’s value either. Sometimes even minor renovations in the kitchen or bathroom can increase a home’s value. 

Pay off Debt 

If you’re in over your head in consumer debt, using your home’s equity to pay it can help. Since mortgages, even second mortgages, have a lower interest rate than most credit cards, you’ll save money by consolidating your debt. 

You’ll have one payment to make each month which decreases the risk of missing a payment and you’ll have more money to pay extra toward the debt’s principal to pay it off. 

Just be careful. When you wrap consumer debt into your home, it goes from unsecured debt (no collateral) to secured debt. If you miss too many payments, you could lose your home, so make sure the payment is something you can easily afford. 

Pay for College 

If you aren’t eligible for student loans or just don’t want them, using the equity you’ve built up in your home can help pay for college. With the low interest rates HELOCs, home equity loans, or even cash-out refinances offer, you can save money and help your child through college. 

Emergency Savings 

After 2020, many people are left without an emergency savings account. If you can’t build yours back up, tapping into your home’s equity can help. Your home’s equity is like an automatic savings account, but if you want access to it, you’ll need a home equity loan or HELOC. 

If you use the home equity loan or cash-out refinance, you’ll receive the funds in one lump sum. Invest the funds in a safe account, like a CD or bonds, and let the money grow, while making it harder to access. 

If you use a HELOC, the money sits in an account that you can access, but don’t have to. Just let it sit there and if emergency strikes, you have it. If not, you don’t owe anything for the peace of mind it provides. 

Medical Bills 

Some people use their home equity to pay off unexpected medical bills. Because of the low interest rates, it often costs much less than charging the debt on a credit card. This gives you peace of mind that you won’t have collectors knocking on your door, and you won’t pay excessive interest charges for something you didn’t expect. 

Key Takeaway 

Using your home’s equity for any purpose can be smart, as long as you can afford the payment and can’t access the funds any other way. Know your options, compare the costs, and choose the loan that’s right for you.

This article is provided by EveryIncome.