Home Equity Loan – What is it and How Does it Work?

You have home equity if you’ve paid off some of your mortgage. This means you have a stake in the home’s value. If you sold the house today, you’d receive the equity in cash. But while you live in the home, that money sits there as long as you own it.

The good news is you can tap into it using a home equity loan.

What is a Home Equity Loan?

A home equity loan is a mortgage. It takes a second lien position behind the first mortgage. It uses your home as collateral, just like your first mortgage, but it provides access to the equity you’ve built.

Home equity loans usually have a fixed rate with a 5 to 30-year term, and your home is the collateral, but the loan is in the second lien position. This means the first mortgage lender gets paid first; then, home equity lenders get paid when you sell the property or if you default. 

How Does a Home Equity Loan Work?

To get a home equity loan, you must have equity in the home. You can get equity when you pay your mortgage down or right off the bat by making a down payment on the home.

Your home equity is what’s left over from your home’s current value after accounting for any outstanding mortgage loans. If you have over 20% equity in the home, you may be able to borrow money from the equity with a home equity loan.

To get a home equity loan, you’ll complete an application and prove that you can afford the loan to the mortgage lender. Then, you’ll provide paystubs, W-2s, and bank statements like you did with your first mortgage.

If you qualify and have over 20% equity in the home, the lender will fund your loan, giving you the equity in one lump sum.

You then make principal and interest payments on the loan with a fixed interest rate. This mortgage payment is separate from your first mortgage payment.

How do I Calculate Home Equity?

Before applying for a home equity loan, determine how much equity you have in your home. Most lenders offer home equity loans up to 75% – 85% of your home’s value, including your first mortgage.

To see how much equity you have, take your home’s current value and subtract any outstanding mortgage loans.

For example, if your home is worth $350,000 and you have $200,000 in mortgage loans, you have $150,000 in equity. If a lender allows an LTV of up to 85%, you could have total outstanding loans of $297,500, leaving $97,500 to borrow in a home equity loan.

How Does Borrowing from Home Equity Work?

When you take out your home equity, you liquidate a portion of your equity. So, you’ll always leave 15 – 20% of your equity untouched. Lenders need that buffer in case you default on your loan.

You’ll take out a second mortgage on which you pay principal and interest for the entire term. You receive the funds three days after the closing and can do with them what you want.

How to Use Home Equity Loans

There’s no right or wrong way to use home equity loans. The most common way is to use the funds to renovate your home. Investing the money back in your home provides the best return on investment. It may also allow you to write off the interest paid on the portion used to improve your home.

Other uses of home equity funds include:

  • Debt consolidation
  • Weddings
  • Pay for college
  • Save for an emergency fund
  • Buy a vacation home

How do I Qualify for a Home Equity Loan?

To qualify for a second mortgage on your home, you must prove the following factors:

  • · You have good credit – Lenders use your credit score to determine if you’re a good risk. If you have bad credit, you are a higher risk of default. Most lenders require a credit score of at least 680 for a home equity loan.
  • · You have stable income – You must prove you have enough income to afford both mortgage payments (first and second), plus your other monthly obligations. Lenders prefer it if you’ve been at the same job for two years.
  • · You have a low debt-to-income ratio – Lenders prefer a debt-to-income ratio of 43% or less. This means your total debts, including the home equity loan payment, are less than 43% of your monthly income.

How to Find the Best Home Equity Loan

Do the following to get the best rates and terms on your home equity loan.

  • · Improve your credit score

Check your credit history for free. Fix any issues you find, such as late payments, collections, or credit lines with over 30% of the credit line outstanding. These changes will help your credit score and increase your chances of getting good terms.

  • · Pay down your debt

Keep your DTI as low as possible. 43% is the maximum, but the fewer debts you have, the more likely you will get approved.

  • · Prove you’re a good borrower

Any way you can show the lender you are a good borrower helps. This is a great start if you have a solid payment history on your first mortgage. Also, if you have a large amount of equity in your home but only draw some of it, you’ll have a good chance of approval.

Summary

home equity loan has many uses and is easy to get when you have average qualifying factors. So, if you have equity in your home, tap into it with a home equity loan. Whether you need to do home renovations, have debt to consolidate, or have other reasons to use the funds, a home equity loan can be an affordable way to get it.

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