What is a home equity loan? How does it work?
A home equity loan is sometimes called a second mortgage because it can be taken out as a second lien against a home in addition to the primary mortgage. A homeowner approved for this kind of loan gets a lump sum payment upon closing. Because a home equity loan is considered a secured loan backed by your home as collateral, it typically comes with a lower interest rate compared to unsecured borrowing options like credit cards or personal loans.
Depending upon your unique circumstances, a home equity loan can be a valuable tool for you to leverage the equity in your property to meet various financial needs.
Types of home equity loans
Home equity loans are usually offered in the following three types:
- Traditional home equity loan: This type of home equity loan becomes a second mortgage on your home. Traditional home equity loans allow you to borrow a fixed sum of money from the equity in your home, usually at a fixed interest rate. Repayment is determined by an amortization schedule based on a predetermined repayment period. Because interest rates on home equity loans are typically fixed, your monthly payment will remain the same for the life of the loan.
- Home equity line of credit (HELOC): This type of home equity loan is a short to medium term loan with a lot of flexibility. With a HELOC, you only borrow what you need, and you only pay interest on the money you’ve borrowed. Since most HELOCs have 5, 7 or 10-year terms, the balance of your HELOC is typically converted into a traditional second mortgage once it expires. This means you’ll end up with a second mortgage in the amount of your HELOC balance. Please note: Discover® Home Loans offers home equity loan and mortgage refinance products, but does not offer HELOCs.
- Cash out refinance: This type of home equity loan allows you to increase the amount of your current mortgage by refinancing the total borrowed amount into a new loan. Instead of having two mortgages, a cash out refinance loan combines the borrowed amount with the principal of your existing mortgage into a single loan with one monthly payment as well as an updated interest rate and term.
What is home equity?
Equity is the difference between the current value of your home and the outstanding balance on your mortgage.
Your home is one of your greatest assets. As you pay down your mortgage and property values in your neighborhood rise, the cash value of your home increases. That cash value is your home equity — it's the value of your homeownership.
How much home equity do you have?
To calculate your home equity, you must know the total amount of all debts secured by your home (e.g. your current mortgage, business loans or private debts), and you must know the current fair market value of your home.
Simply put, your home equity can be calculated by subtracting all debts secured by your home from your home’s fair market value.
- For example, if your home is worth $400,000 and your current mortgage is $240,000, then you have $160,000 of equity in your home.
Your borrowing ability depends on your combined loan-to-value (CLTV) ratio. CLTV is your loan amount plus your mortgage balance, divided by your home value.
- In the example above, you could potentially borrow up to $120,000 of your home equity with a lender that approves borrowing up to a 90% CLTV limit. This is because $120,000 plus the $240,000 mortgage balance divided by the $400,000 home value is equal to 90% CLTV.
CLTV borrowing limits vary by lender, and your borrowing ability will also depend on other factors for eligibility such as your credit score, credit history, and debt-to-income (DTI) ratio.
What are the requirements to qualify for a home loan?
Eligibility requirements for a home equity loan will vary by lender.
As an example, Discover Home Loans looks at several factors to determine if you are a qualified borrow, including:
- Equity in your home: You will need to have enough equity available in your home to borrow from. This means that a loan amount between the borrowing limits of $35,000 to $300,000 added to all other loans secured by your property must equal below 90% CLTV for you to take out a home equity loan.
- Qualifying credit score: You will need a credit score of 620 or above. The higher your credit score is, the more likely you will be approved for lower interest rates on your loan.
- Debt-to-income ratio below 43%: When you’re looking to borrow money, it’s typically a good idea to make sure that the amount of your existing debt payments divided by your income is below 43%.
- Documented income: Whether you’re earn salaried or hourly wages, are self-employed or work as a freelancer, you will need to provide documentation that shows you make enough income to pay back the loan.
- Credit history: All lenders will want to see that you have a history of making payments on time.
In addition to this details, an appraisal report will be ordered by a lender to assess the value of your home. While this may be a cost charged back to you as the borrower, Discover Home Loans does not require you to pay any appraisal fees, origination fees, or other costs at closing.
Pros of home equity loans
A home equity loan can be a useful financial tool for homeowners who want to tap into the equity in their property to fund large expenses. This is because they have features such as:
- Lower interest rates: Home equity loans typically have lower interest rates compared to other forms of credit, such as personal loans or credit cards.
- Large loan amounts: Home equity loans can provide access to significant amounts of money, depending on the value of your home and the amount of equity you have built up.
- Flexible use of funds: You can use the funds from a home equity loan for a variety of purposes, such as home improvements, debt consolidations, or paying for major expenses like college tuition or medical bills.
- Tax-deductible interest: The interest paid on a home equity loan may be tax-deductible if the funds are used to buy, build, or substantially improve the home that secures the loan. Be sure to consult with a tax professional to understand options for your situation.
It is also important to speak with a personal banker who can evaluate your set of circumstances and guide you through the process of selecting a home equity loan.
Cons of home equity loans
There are some potential downsides to borrowing money using a home equity loan that you should be aware of, including:
- Risk of foreclosure: Because your home serves as collateral for the loan, failing to make payments on a home equity loan can result in the loss of your property.
- Closing costs and fees: Home equity loans can come with closing costs and fees, which can add to the overall cost of the loan. However, some lenders offer to cover these fees, so comparing your options before making a decision can help you decide what works best for you.
- Reduced home equity: Taking out a home equity loan reduces the amount of equity you have in your home, which can limit your financial flexibility and borrowing power in the future.
- Possible impact on credit score: Applying for a home equity loan will result in a hard inquiry on your credit report, which may temporarily lower your credit score. Additionally, having a large outstanding debt can impact your credit utilization ratio, which is a significant factor in determining your credit score.
In general, home equity loans are not always the best financing option for short-term expenses. For example, if you use a 10-year term home equity loan to purchase a car that you own for five years, you could end up paying more interest than you would with other financing options.
This is because you’re paying on the loan for a longer period than you likely would with a car loan. While a car loan may have higher interest rates, the term of the loan is not as long, so the financial benefit provided by using a home equity loan may be negligible in this case.
What can you do with a home equity loan?
Home equity loans offer powerful financing opportunities for homeowners because of their flexibility.
You can use the money you get from a home equity loan to pay for major expenses or life events, to consolidate high-interest debt, to improve your home, or pay for other things like education expenses.
Improve your home
Using the equity you’ve earned with a home equity loan to improve your home is a smart way to leverage your funds. In fact, some improvement projects may instantly increase your equity by increasing the value of your home.
High-interest debt consolidation
High-interest rates on unsecured debts can become a hurdle to becoming debt-free. Since home equity loans usually have lower interest rates than unsecured loans, using a home equity loan to pay off high-interest debt can be a smart move. You may enjoy a single lower monthly payment on your new loan compared to payments on interest and principal across multiple bills.
However, you may want to avoid using a home equity loan to consolidate high-interest debt if you are going to accrue new high-interest debt again.
Debt consolidation is designed to reduce financial stress, but using a home equity loan unwisely will only create more financial stress for you in the future if you obtain one for the wrong reasons.
Pay for big-ticket purchases
Instead of using a credit card or unsecured personal loan to pay for big-ticket items (like school tuition, a wedding or a luxury vacation), you can use a home equity loan.
You could also use a home equity loan to pay off an unexpected expense. Home equity loans enable you to use your big-ticket asset (your home) to pay for all kinds of big-ticket expenses.