If you have equity in your home, it means that your home will likely sell for more than what you owe on your mortgage. Not everyone is fortunate enough to be in this situation, but if you are, you have some options for turning that equity into spending power.
Among the options available to those with home equity is a home equity loan. If you’ve been considering a home equity loan to fund a remodel, to purchase a home, or to undertake another large project, you’re not alone.
If you’ve heard about home equity loans but you’re not sure what they are, or you’re not sure if you qualify, the following information can benefit you.
What is a Home Equity Loan?
A home equity loan is, put simply, a loan that borrows against the equity in your home.
Let’s say you owe $150,000 on your mortgage but your home is valued at $300,000. You would technically have $150,000 in equity that you can borrow against in the form of a home equity loan.
Home equity loans tend to offer much lower interest rates than traditional loans because they’re considered secured loans. In other words, your home and its associated equity act as collateral.
What’s the Difference Between a Home Equity Loan and Home Equity Line of Credit (HELOC)?
When you take out a home equity loan, you borrow against the equity in your property. However, there’s another option for those with home equity, as well: a home equity line of credit, or HELOC.
If you’re wondering what the difference is between the two, the answer is not much. They act in much the same way. The only difference is that whereas you’re securing a loan with a home equity loan, you’re obtaining credit with a HELOC.
In both situations, you’re borrowing against the equity in your home. However, when you obtain a home equity loan, you receive lending funds like you would in any other loan. When you obtain a HELOC, you obtain a credit card or checks that you can use to borrow money against your home’s equity.
How to Qualify for a Home Equity Loan
It’s important to understand that every lender has their own requirements, so you might face some additional requirements that aren’t listed here. However, these four requirements are nearly universal regardless of where you obtain your home equity loan.
Any time you take out a loan you have a better chance if your credit score is high. The same is true for anyone wishing to take out a home equity loan.
For home equity loans specifically, you’ll typically need a credit score of 620 or higher. While it’s sometimes possible to secure a home equity loan with bad credit, try to improve it as much as possible before it comes time to request the loan.
A Debt-to-Income Ratio of 45%
Your debt-to-income ratio, or DTI, is determined by a variety of calculations, but what it amounts to is the percentage of your monthly income that goes toward your monthly debts. Typically, in order to secure a home equity loan, you’ll need a DTI of 45% or lower.
Some lenders will tolerate DTIs up to 50%, and others, called high-DTI lenders, will tolerate a bit higher. However, you’ll usually pay for it in higher fees and interest rates. It’s also worth noting that some lenders will ask for your DTI to be less than 43%, so again, make sure you check with your lender for individual requirements.
Equity of 15%-20%
Most lenders request that your equity be at least 15% to 20% of the overall value of your home. For instance, let’s say your home is appraised at $250,000. You should have an equity of between $37,500 to $50,000 in order to qualify. Of course, higher is better.
Solid Payment History
Lenders have a lot of requirements, but almost all of them exist to determine one thing: how likely is it that you’ll pay on time and fulfill your financial responsibilities.
To this end, having a long history of consistently paying your bills on time can help you immensely when it comes time to request a home equity loan.
Pros and Cons of a Home Equity Loan
There are several pros and cons to applying for a home equity loan, and it’s worth knowing them before you decide that this is the right option for you.
Pros of Home Equity Loans
One of the most attractive aspects of a home equity loan is that it typically comes with a fixed interest rate. This means that even if interest rates rise, your payments aren’t affected by that increase.
Another benefit of a home equity loan is that it costs less to borrow in this way than it would if you went through a traditional lending process. Finally, there are no restrictions as far as how you can use the money, so you can utilize it for whatever you need.
Cons of Home Equity Loans
Along with the benefits are a few drawbacks, as well. First, using your home as collateral is inherently risky. If you run into financial hardship and fall too far behind on payments, you could lose your home.
Secondly, when compared with a HELOC, home equity loans have a higher interest rate. It’s for this reason that many people opt for a HELOC instead. This is particularly true for people who want to use HELOC funds for a down payment.
Finally, there are quite a few closing costs and other fees associated with a home equity loan. While these can often be included in the overall loan amount, it’s important to know about them before you sign on the dotted line. This is particularly true if you’re using the funds for real estate investments or down payments since that means you’ll probably be paying other fees — such as realtor fees — as well.
While there are many benefits to obtaining a home equity loan, there are drawbacks, as well. It’s important to do your research and consult with a real estate professional who has experience helping people through the lending process. While only your lender can explain the specifics, those who have experience in real estate can help you avoid scams and costly mistakes, which can save you in the long run.