Buying a home is often considered superior to renting one because mortgage payments build home equity, an asset you can convert back to cash in various ways. One popular way to tap into your home equity is to borrow against it using home equity loans.
If you’re a homeowner, here’s everything you need to know about this form of equity financing.
What is Home Equity?
Home equity is the portion of a home’s current market value that you own free and clear. In other words, it’s typically the difference between your house’s price and its remaining mortgage balance. If you sell your property, your equity would be your net proceeds.
Your home equity should steadily increase as you pay down the balance of your mortgage. However, it can also fluctuate with the value of your house due to the growth or decline of your local housing market.
👉 For example
Say you buy a house worth $300,000. Your 20% down payment is $60,000, and your mortgage balance is $240,000. At this point, your $60,000 down payment would be your only equity in the property.
Five years later, you’ve paid down the mortgage balance by $20,000, and the property value has increased by $40,000. As a result, your new home equity would be $120,000.
What are Home Equity Loans?
Home equity loans are a form of home equity financing. They let you tap into the equity you’ve built up in your home and use it as collateral for your credit account.
Home equity loans require that you use your house as collateral, and they often come with relatively generous terms, including lower than average interest rates.
👉 For example: The average home equity loan interest rate at the end of 2021 was 5.96%[1]. Meanwhile, personal loan interest rates averaged 10.28%, and those with less than excellent credit paid even more[2].
In addition, it may be easier to get home equity financing than an equivalent unsecured account. Your equity serving as collateral makes lenders feel more secure. As a result, home equity financing can be a valuable tool for expensive or long-term endeavors like home improvements and debt consolidation.
Those advantages come with a risk, of course. If you can’t pay the loan you could lose your home.
👉 HELOCs are another popular form of home equity financing. The primary difference between home equity loans and HELOCs is their structures. A home equity loan is an installment account like a mortgage, while a HELOC is a revolving line of credit that functions more like a credit card.
How Does a Home Equity Loan Work?
A home equity loan is an installment debt that functions as a second mortgage, and people often refer to it as such. If you qualify, your lender gives you a lump sum that you pay back in monthly installments over the life of the loan, starting immediately.
Like traditional mortgages, home equity loans typically have fixed interest rates and extended repayment terms. The term can be anywhere from five to 30 years. However, your actual loan terms depend on your credit score, principal balance, and lender.
📗 Learn More: If you want to pursue home equity financing, a great credit score will help you get approved at the interest rate you want. Learn how to raise your score: 5 Ways to Improve Your Credit Score Fast
How Much Can You Borrow with a Home Equity Loan?
Home equity loans usually let you borrow around 80% to 85% of your home’s value when combined with your other outstanding mortgage debt. In other words, lenders are willing to give you a home equity loan that resets your home equity to no less than 15% or 20%, though it varies somewhat depending on your credit score.
Lenders typically express this requirement as a maximum combined loan-to-value (CLTV) ratio. That equals your total outstanding mortgage and home equity loan balances divided by your home’s current market value.
👉 For example
Say you buy a house for $400,000 by putting down $80,000 and financing the remaining $320,000 with a mortgage. Five years later, you’ve paid down your mortgage balance to $280,000, and your house’s value has increased to $450,000.
At that point, you have $170,000 in home equity, $280,000 in mortgage debt, and a $450,000 property value. Your current CLTV ratio would be $280,000 divided by $450,000, which equals 62%.
You want to improve your house, so you decide to take out a home equity loan. Your lender tells you that they’ll let you have a maximum CLTV of 80%.
To calculate your maximum home equity loan amount, multiply 80% by your $450,000 home value to get $360,000, then subtract your current mortgage balance of $280,000 to get $80,000.
To double-check your math, divide your home equity after the new loan by your home value. It should equal the inverse of your CLTV, which is 20% in this case.
For example, your $170,000 home equity before the loan minus the $80,000 of new debt equals $90,000, which is 20% of your current $450,000 home value.
Home Equity Loan Pros and Cons
Using a home equity loan is a significant decision with long-lasting financial repercussions. Here’s what you should know about the pros and cons involved before applying for one.
✔️ Pros
- Large lump sum available to fund significant projects
- Fixed interest rates and monthly payments are easy to budget for
- Lower interest rate than many other installment loans
- Use the funds for many different purposes
- Loan interest is an itemized tax deduction if used to improve the home
❌ Cons
- Closing costs can be high, reducing interest savings
- Immediate and significant reduction of your home equity
- Market fluctuations can cause you to owe more than your house is worth
- Lenders can foreclose on your house if you default on your debt
As you can see, there’s a lot to consider before you take out a home equity loan. Ultimately, the primary reason to take out a home equity loan is to borrow a significant lump sum at a relatively low interest rate that you can use for whatever you need.
Meanwhile, the most significant downside to these loans is the increased risk involved. Taking out a second mortgage eliminates the equity you’ve built and increases the likelihood that a drop in its market value could put you underwater.
⚠️ If you owe more than the house is worth, you’ll have to take a loss to sell the property. That can keep you stuck living in the home, even when you’d prefer to leave. In addition, defaulting on the account could result in foreclosure.
Where to Get a Home Equity Loan
If you’re interested in home equity financing, a great place to start your search is with the lender holding your existing mortgage if you have a good relationship.
However, that shouldn’t be your only stop. Like with mortgages, it’s essential to shop around with multiple lenders to get the best home equity loan. Try reaching out to other banks, credit unions, and mortgage companies.
A good rule of thumb is to get between three and five offers. That will ensure that you have an accurate understanding of the options available and helps you negotiate from a position of strength.
Finally, make sure you review the offers in detail. Don’t just go for the one with the lowest interest rate on the sticker. Details like closing costs, ongoing fees, and repayment terms significantly impact your total borrowing expenses.
If you want help, it may be worth working with a mortgage broker to guide you through the process and explain the specifics of each option’s terms.
