A Homeowner’s Guide To Home Equity Loans

If you have a big expense heading your way, you might want to access the capital locked up in your home. A home equity loan offers some homeowners an opportunity to tap into their existing equity. Homeowners build equity with each mortgage payment.

Let’s explore what home equity loans are, how they work, and when one might be right for you.

What Is A Home Equity Loan?

When you make payments on your mortgage or put a down payment on your home, you build equity. So maybe you should first ask “What is home equity?” It's the total of your home’s current market value after subtracting the balance of any outstanding mortgages. In other words, it's the portion of your home that you own.

For example, let's say you buy a home worth $200,000 and put down $40,000, or 20%. You'd automatically have $40,000 of equity in your home when you close on your home. When you finish paying off your home, you have 100% equity in your home.

Your equity is often expressed as a loan-to-value (LTV) ratio, a figure that measures the percentage of your home's value financed by the loan.

Now, what is a home equity loan?

A home equity loan enables you to tap into the equity you've built up in your property. Your home serves as collateral to the loan, which means it provides a bit of insurance to your lender that they will get their money back if you fail to pay off your home equity loan.

How Do Home Equity Loans Work?

A home equity loan is usually a fixed-rate loan with a loan term of 5 – 15 years that provides the borrower with a lump sum payment upfront. You may use your home equity loan money to make property improvements or other expenses.

Lenders will not let you borrow 100% from your equity. For example, Rocket Mortgage^® will allow you to borrow up to 90% of your home’s current value.

Once you borrow the money, you repay it by making monthly payments on top of your primary mortgage payment. It's why a home equity loan is often called a "second mortgage."

Note that home equity loans typically have a lower fixed rate than other loans because the bank can use your home as collateral – in other words, if borrowers quit making payments on a home equity loan, the lender can repossess the home.

What Are Home Equity Loan Requirements?

Now, for how to get a home equity loan: You must meet certain requirements to qualify.

First, you must have enough available equity to borrow against. At a minimum, you must have at least 15% – 20% equity in your home.

You must also meet certain credit score, debt-to-income (DTI) ratio, income and payment history requirements.

• Credit score: Your credit score is a three-digit number that shows how well you've handled repaying debt in the past. Typically, you must aim for a credit score higher than 620 to qualify for a home equity loan.
• DTI ratio: Your DTI summarizes the debt you have related to the amount of income you bring in. You can calculate it by separately adding up the amount of debt and gross income you have and dividing your total monthly debt by your total gross monthly income. Shoot for a DTI in the 43% – 50% range.
• Income: You must prove sufficient income to repay your loan by providing an income history over 2 years or more.
• Payment history: You must also have a reliable payment history, meaning that you must have made your mortgage payments regularly and on time.

What Can Home Equity Loans Be Used For?

There are no restrictions on using the money you receive from a home equity loan. Homeowners use a home equity loan for many purposes, including (but not limited to) paying for home repairs and renovations and paying off higher-interest debt. For example, people often use home equity loans for a variety of reasons, such as:

• Home improvements
• Debt consolidation
• Emergency expenses
• Education
• Investments
• Weddings

These are not the only reasons you may want a home equity loan – the options are limitless.

When Does A Home Equity Loan Make Sense?

Home equity loans are useful when homeowners need a large sum of money to cover a specific expense they can budget for or to consolidate higher-interest debt. Home equity loans may not make sense for smaller expenses spread out over time.

What Are The Pros And Cons Of Home Equity Loans?

There are pros and cons to taking out a home equity loan compared to unsecured debt like credit cards or personal loans. Let's take a look at the benefits and drawbacks.

Pros Of Home Equity Loans

• Lower interest rates: Compared to personal loans and credit cards, home equity loans may have a lower interest rate. It's a good idea to compare interest rates before deciding the type of loan you want to pursue because the higher the interest rate, the more you'll pay for the loan over time.
• Fixed-monthly payments: Instead of a variable payment, you'll have a fixed payment, meaning you know what to expect to pay every month – there are no surprises.
• No restrictions on how you use the money: You can use your home equity loan however you wish, giving you a lot of freedom and flexibility.

Cons Of Home Equity Loans

• Application process can take time: The application process can take time, because your lender will order an appraisal of your home to find out what it is worth. Your lender must also check your qualifications through underwriting and review your application. Receiving your funds can take anywhere from 2 weeks to 2 months.
• Risk of losing your home: A home equity loan uses your home as collateral. This means that if you fail to make payments on your home, your lender uses it as security to protect itself.
• Lowers your available equity: When you take out a home equity loan, you lower the equity in your home because you're subtracting money from the amount you've already paid toward your home.
• Adds to your household debt: When you get a home equity loan, you'll make two mortgage payments – your primary mortgage and second mortgage. That's less that can potentially go toward fun things, like going out to dinner or taking vacations.

How To Get A Home Equity Loan

Applying for a home equity loan will seem very familiar – it's very similar to getting a mortgage. Let's take a look at the process.

1. Shop For Lenders

First, shop for lenders. Homeowners can use the same lender with which they took out their primary mortgage or they can work with another lender. However, note that online lenders, community banks, and credit unions may be able to provide competitive rates.

Different lenders may also have different loan-to-value (LTV) ratio requirements.

Get preapproved for a home equity loan to compare interest rates and repayment terms. Interest rates vary from lender to lender. Before applying for a home equity loan, compare home equity loan rates. You may overpay for your home equity loan if you don't get quotes from multiple lenders.

2. Submit An Application

Once you've selected a lender, you must submit an application online and provide the lender with some income and tax information to start the process.

While you're submitting your application, you can also determine how much cash you need. If you have an exact amount in mind, it might be easy, but remember that as some projects unfold (like home renovation projects), they may cost more than you anticipate.

3. Get Your Home Appraised

A lender will require you to get a home appraisal.

How does a home appraisal work? A licensed appraisal contractor determines the fair market value of a home by comparing recent sales of comparable homes in the area, as well as a tour and analysis of the property.

While the lender will select the appraiser, you are responsible for paying the appraiser and being available for in-home inspections if necessary.

4. Work With Underwriting

Next, just like when you undergo the home mortgage process for the first time, you must undergo an underwriting process, which requires you to submit income statements, tax statements and other financial documentation. Your lender will let you know what types of materials you will need to submit, so respond as soon as possible to speed up the process.

5. Close On Your Home Equity Loan

Closing on a home equity loan requires signing documents and paying closing costs usually between 2% – 6% of your total loan amount. For example, taking out a $50,000 home equity loan translates to closing costs of $1,000 – $3,000.

You can also ask your lender to have some of the closing costs added to the loan, but note that this means your loan will increase.

6. Start Making Payments

Once the loan disperses, you must start making monthly payments toward your home equity loan. Some lenders may require that you set up direct deposit or get a checking or savings account with them to qualify for a lower interest rate, or as a condition of the loan.

Check with your lender for more information about how repayment might look and about all your payment options.

How To Get A Home Equity Loan

If you decide that a home equity loan is a good fit for your situation, you’ll need to complete several steps to get your hands on the funds you need. Take a closer look at the step-by-step process below.

1. Decide How Much Cash You Need

A home equity loan involves a lump sum transaction, which means you won’t be able to easily tap into more funds along the way. With that, you’ll need to determine exactly how much cash you’ll need upfront.

If you are consolidating debt or making a big purchase, it might be easy to nail down the exact amount. If you are embarking on a home renovation or other major project, it’s usually a good idea to give your original budget some wiggle room.

2. Check Your Credit Score and Debt-To-Income Ratio

Your credit score will not only affect your eligibility for a home equity loan, but also the interest rates you’ll be offered. Though it’s possible to obtain a home equity loan with bad credit, borrowers with higher credit scores typically reap the benefits of lower interest rates. In general, home equity loans typically require a credit score of 680 or higher, so it’s important to check the strength of your score before applying.

While you’re checking your credit score, you should also consider your DTI ratio, which represents the percentage of your monthly income that goes toward debt payments such as mortgages, credit cards and other loans.

To qualify for a home equity loan, your DTI cannot exceed 45%. To calculate your DTI, add up all your monthly debt payments and divide the sum by your gross monthly income before taxes, then multiply the result by 100 to convert it into a percentage.

3. Compare Interest Rates

Interest rates vary from lender to lender. Before applying for a home equity loan, it’s critical to compare mortgage rates. If you don’t get quotes from multiple lenders, it’s very easy to overpay accidentally.

4. Obtain A Home Appraisal

To know how much equity you have in your home, you need to know how your home is valued, which means a home appraisal is a key step in the process of obtaining a home equity loan.

5. Close On The Loan And Receive The Funds

From the point of application to the point of approval and the release of funds, the home equity loan process can take anywhere from two weeks to two months. To speed up the process, be prepared with the documents your lender might need, including proof of income records and mortgage statements.

Once you have the funds in hand, be prepared to start making regular monthly payments.

Home Equity Loan FAQs

Do you still have questions about home equity loans? Learn more about them and how to get one through these frequently asked questions.

How do home equity loan rates compare to mortgage rates?

A home equity loan rate will be higher than the interest rate of your primary mortgage because a second mortgage is subordinate, or "second place," to your primary mortgage. If you default on your payments and the lender sells your property to get its money back, the holder of the primary mortgage can recoup its expenses first. Therefore, interest rates for home equity loans will be higher no matter what the market conditions are for primary mortgages.

What is the difference between a home equity loan and a mortgage refinance?

A mortgage refinance is a restructuring of the entire current mortgage with new terms, while a home equity loan means you borrow against the available equity. The goals of a refinance and a home equity loan are different.

A refinance often means changing your mortgage payments in some way, typically by increasing or lowering your payments. You may want to increase your mortgage payments to repay your loan faster. You may choose to refinance to lower your mortgage payment through refinancing and therefore, reduce the amount you pay per month, cushioning your budget more.

On the other hand, a home equity loan doesn't change your current mortgage and has a main goal of pulling money out of your home equity.

Can I deduct the interest on a home equity loan when I file my taxes?

The 2017 Tax Cut and Jobs Act only allows borrowers to deduct the interest on a home equity loan if they used the money to buy, build or repair a home. This may change after the act expires in 2025.

Are there other ways to access my home equity?

You can access your home equity in other ways. For example, you can access home equity through a cash-out refinance and home equity line of credit (HELOC).

Cash-out refinancing means replacing your current first mortgage with a new one by taking out more than what you currently owe on your home. You'll have your income and assets verified just like in a home equity loan, but you'll get a check instead of writing a check to your lender at closing. In addition, you won't make two mortgage payments like you would with a home equity loan – you'll have just one payment.

A HELOC is a revolving line of credit that taps into your home equity. It works a lot like a credit card, and has a draw period and a repayment period.

Can I get a home equity loan with bad credit?

Most lenders require good credit to qualify for a home equity loan. Lower credit scores may lead to higher interest rates if you qualify.

Don't have a great credit score? Never fear. You can boost your credit score a few ways – make on-time payments, pay off debt, don't use credit, consolidate debt, leave old accounts open and more.

The Bottom Line

Turn to the equity you've built up in your home to pay for home improvements, emergency repairs on your car, college – whatever life throws your way. Borrowers use equity for a wide range of reasons.

Your home is collateral to the loan, which means your lender can recoup its costs if you stop making payments on your home equity loan.

You must meet certain requirements to qualify for a home equity loan. The basic steps of getting a home equity loan include the following:

1. Shop around (look past the lender you used for your primary mortgage – you may be able to find a better interest rate elsewhere).
2. Submit an application.
3. Get your home appraised.
4. Go through underwriting.
5. Close on the loan.
6. Repay the loan according to your lender's terms and conditions.

Ready to get started? Apply for a Home Equity Loan with Rocket Mortgage^® today.