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How Does a Home Equity Loan Work? A Beginner's Guide

When you need cash, your home might be the first place you turn. Your home’s equity can be a viable alternative to credit cards and personal loans when you have major expenses. Is it the best option? That depends on several factors, including how you plan to use the money.
When you need cash, your home might be the first place you turn. Your home’s equity can be a viable alternative to credit cards and personal loans when you have major expenses. Is it the best option? That depends on several factors, including how you plan to use the money.

You could be sitting on a pile of cash without realizing it — the equity in your home.

If you need money for home repairs or renovations, pay off debt, purchase a second home or investment property, or a myriad of other needs, the equity in your home could be a viable financing option.

We’re covering some of the most common questions about home equity loans so you can make an informed borrowing decision.

What is a Home Equity Loan?

When your home has more value than what you owe on your mortgage, you have equity in your home. You can turn this equity into cash via a home equity loan by using your home as collateral.

A home equity loan (HEL) is basically a second mortgage, which means you get a lump sum and repay a fixed amount every month. The rates are usually fixed, so your payments will never fluctuate. Repayment periods are usually 5-15 years, depending on your lender and loan terms.

What Home Equity Loans Can Be Used For

Home equity loans can satisfy a variety of cash needs, including paying off high-interest credit cards or other debt, sending kids to college, making major home improvements, buying a car, or even investing the money to grow your assets. For example, you might use your money to purchase an investment property to flip and sell or use for rental income.

Your reason for taking out a home equity loan is important. If you’re using the money to make upgrades to your home, you can deduct the interest from your taxes. However, the interest isn’t tax deductible if you’re consolidating debt.

Before taking out a home equity loan, it’s important to consider what tax benefits, if any, you could receive.

Home Equity Loans Pros and Cons

Like any other type of loans, a home equity loan might or might not be your best solution.

On the plus side, the ways you can use a home equity loan are flexible, which makes it an attractive choice for borrowers and lenders alike, provided your home is worth more than you owe.

You don’t have to use a home equity loan for home-related expenses. The interest rates are significantly lower than credit cards or personal loans, which can help keep your total borrowing costs low.

In addition, loan amounts are usually higher than what you could get from a personal loan or your credit card. If you have large expenses, such as a new roof, new car, or a year’s college tuition, a home equity loan may be your only option for funding.

Home equity loans have several downsides to consider, particularly concerning the overall cost of the loan. Closing costs can often offset any savings you see from the lower rates, so you could be paying more than you realize when the loan is satisfied.

Also, since the loan is basically a second mortgage, the bank could foreclose on your home if you don’t keep up with the payments. If finances get tight, you may opt to pay this loan vs paying on a credit card, which would result in a costly late payment and added interest.

Many people think of their homes as a personal ATM, but it’s best practice to reserve your equity for expenses that will add value to your home, generate a higher income for your family, or bring value to your life.

How to Get a Home Equity Loan

You don’t have to get your home equity loan from the same lender that provided your mortgage. It’s in your best interest to shop various lenders to find the best interest rate and repayment terms.

Your lender will check your credit score and may appraise your home to move forward with the loan. The final decision is usually based on several factors:

  • Most lenders require 15%-20% minimum equity in your home
  • Reliable income record, even if you’ve changed jobs
  • Debt-to-income ratio of up to 43% (some lenders may consider DIT of up to 50%)
  • Minimum credit score of 620

If you have poor credit, you still may be able to qualify for a home equity loan, since you’re using your home as collateral. This is a sounder way for lenders to secure their risk, but approval isn’t guaranteed. Your credit score isn’t an automatic disqualifier, but it can determine your interest rate. The lower your credit, the higher your interest rate is likely to be.

Is a Home Equity Loan Your Best Option?

Home equity loans can be a satisfactory option in many cases, but it’s in your best interest to explore other options that might be better. Home equity lines of credit (HELOCs) are also popular choices that offer similar benefits of HELs. Credit cards and personal loans may be more financially sensible in certain circumstances, such as smaller cash needs and shorter repayment terms.

If you’re considering a home equity loan to finance a second home or investment property, it’s in your best interest to partner with an experienced local real estate agent for support and guidance throughout the process. Clever Partner Agents are full-service agents that can help you explore your financing options, and may even provide cost-savings up front in the form of a home buyer rebate.

Connect with a Partner Agent today and start your home buying journey!

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Reuven Shechter

Reuven Shechter is the Outreach Coordinator at Clever Real Estate, the free online service that connects you with top real estate agents to help save on commission. He spreads the word about Clever, disseminating studies to journalists and developing relationships with media outlets. Reuven is passionate about investing in real estate and creating lasting success for families. His writing has been featured in Max Real Estate Exposure, Leverage Marketing, and more.

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