When Is A Home Equity Loan A Good Idea?

When you want to borrow money, choosing the right loan type can have lasting financial implications. If you own your home, want access to cash at a competitive interest rate and are comfortable with a second mortgage payment, a home equity loan could be a great option.

What Is A Home Equity Loan And How Does It Work?

A home equity loan is a type of second mortgage that uses your home equity as collateral to secure the loan. Home equity loans can look a lot like your primary mortgage (also known as a first mortgage) but have different terms and a separate loan balance.

When you take out a home equity loan, the lender gives you a one-time cash payment in exchange for your promise that you’ll pay back the loan with interest. Since a home equity loan is another mortgage, you also agree to a lien on your home.

Your home equity loan agreement will have all the details about the mortgage interest rate (which is fixed throughout the life of the loan) and the repayment schedule, as well as all loan terms and conditions.

How To Qualify For A Home Equity Loan

Before you apply for a home equity loan, you’ll need to know how much equity you have in the property. Thankfully, that’s an easy calculation. Home equity is simply the amount of your home that you own without a lien or mortgage balance. To calculate home equity, take your home value and subtract the amount you owe on your mortgage.

So, if your home is worth $400,000 and you have a $300,000 balance on your mortgage, your home equity is $100,000. To calculate your home equity as a percentage, divide the dollar amount of your home equity by the value of your home and multiply it by 100 (100,000 ∕ 400,000 = 0.25 ✕ 100 = 25%).

To qualify for a home equity loan, you’ll need at least 15% – 20% equity in the property. You’ll also submit a formal mortgage application, which will ask for your personal and financial information.

The lender will then evaluate your creditworthiness by looking at your credit report, credit score, employment history, debt-to-income ratio (DTI) and the value of the home. Most lenders will want to see a consistent income, a credit score of 620 or higher and a DTI below 43% – 50%.

When A Home Equity Loan Might Be A Good Idea

Home equity loans can be an excellent borrowing option for certain homeowners who recognize the pros and cons of these loans. A home equity loan might be a good idea for you if:

• You want to borrow a larger lump sum of money at comparatively low interest rates.
• You want a fixed interest rate and predictable monthly payments.
• You’re using the money for home renovations, or to buy, build or substantially improve your home.
• You’ve done the math and the home equity loan funds will help you save money by consolidating debt.
• You have a plan for how to repay the money and are confident in your ability to take on a second mortgage with additional monthly payments.

Benefits Of Home Equity Loans

Even if you fit into one of the scenarios above, you should review the advantages of using this type of financing to help ensure it’s the right fit for your needs:

• Flexibility: You can use the lump sum from your lender however you choose.
• Competitive interest rates: Home equity loans may have lower interest rates than other loan types, like credit cards or personal loans.
• Fixed interest rates: This type of financing comes with fixed interest rates and predictable payments throughout the life of the loan.
• Tax benefits: A home equity loan’s interest may be tax deductible, depending on how you use the funds.
• Less strict lender requirements: Qualifying for a home equity loan may be easier compared to some other loan types.
• Higher loan limits: Since a home equity loan is secured by using your home as collateral, lenders offer higher limits than other loan types (as long as you have enough equity).

When A Home Equity Loan Might Not Be A Good Idea

Though a home equity loan offers many benefits, it’s important to consider its cons and certain situations where a home equity loan might not be a good idea. For example, if you’re not comfortable using your home as collateral and taking on a second mortgage payment, a home equity loan might not be a good fit.

A home equity loan may not be the best idea if:

• You don’t have a clear repayment plan.
• You don’t know how you’ll manage a second mortgage payment every month.
• You’re not sure how much money you need.
• You need the money quickly.
• You’re spending the money on luxuries or other unnecessary expenses.
• You can find a more suitable loan elsewhere for the purchase you want to make (for example, an auto loan to buy a new car).

Drawbacks Of Home Equity Loans

Unfortunately, like all types of financing, a home equity loan comes with disadvantages. Make sure to consider the following before applying:

• High closing costs: Since a home equity loan is a second mortgage, you’ll need to pay fees at closing. In other words, closing costs can be significantly higher for this than for other types of loans.
• Strict equity requirements: You need to have at least 15% – 20% equity in your home to qualify.
• Collateral requirements: If you default on the loan, you could risk losing your home since you’re using the equity to secure the loan.
• Lump sum payment: You can only borrow money as a lump sum payment from the lender, which means you’ll pay interest on the entire loan amount, even if you don’t use it all. You’ll also have to take out another loan if you end up needing more money.
• Longer funding time: The approval process can take several weeks.

Home Equity Loan Alternatives

If you decide a home equity loan isn’t a good idea for you, there are several other borrowing options you can explore.

Home Equity Line Of Credit (HELOC)

HELOCs are another popular type of second mortgage. Like home equity loans, HELOCs use your home equity as collateral, include closing costs between 2% – 5% of the loan amount and can take several weeks for approval. The key difference between home equity loans and HELOCs is that a HELOC is a revolving line of credit while a home equity loan is paid in a single lump sum.

Rocket Mortgage^® currently doesn’t offer HELOCs.

Cash-Out Refinance

A cash-out refinance replaces your existing mortgage with a new mortgage while providing you with a lump sum of cash. If you have all the qualifications for a second mortgage and are comfortable using your home as collateral but don’t want a second monthly payment, a cash-out refinance may be a good alternative to a home equity loan.

Personal Loan

If you don’t want to put up your home as collateral or you have trouble qualifying for a home equity loan, you might consider a personal loan. Personal loans also tend to have more flexibility and a faster approval process, so if you need the money quickly, it may be a better fit for you.

Credit Card

Credit cards are known for their convenience and flexibility. Credit cards are unsecured lines of credit, meaning you don’t put up any collateral, and you can spend as much as you want as long as it doesn’t exceed your card’s limit. While you can easily apply for a credit card online and potentially get approved in minutes, credit cards often come with significantly higher interest rates than other loan types.

FAQs: When Is A Home Equity Loan A Good Idea?

Still not sure if a home equity loan is a good idea? Consider the answers to these frequently asked questions to help you decide.

Should I get a home equity loan?

Deciding whether you should use a home equity loan will primarily depend on your personal situation. If you have enough equity, can afford the second monthly payment and know the exact loan amount you need, a home equity loan could be a good option.

What are the risks of a home equity loan?

One of the main risks of a home equity loan is that you could face foreclosure if you don’t make your payments on time. You’ll also have to pay closing costs, meet your lender’s equity requirements and go through an approval process.

How can I use my home equity loan?

You can use the proceeds of a home equity loan in any way you choose. Homeowners can use home equity loans to pay for home renovations, education costs or consolidating debt.

Can I access my home equity without refinancing?

There are several ways to access your home equity without refinancing, such as a home equity loan, a HELOC, a reverse mortgage or selling the property.

What credit score do I need for a home equity loan?

Many lenders require a minimum credit score of 680 to qualify for a home equity loan, while other lenders might have minimum requirements ranging from 620 on the lower end to 720 on the higher end.

Will a home equity loan affect my credit?

Applying for a home equity loan will appear as a hard inquiry on your credit report, which may impact your credit score. However, with regular, on-time monthly payments, your credit score should quickly recover.

The Bottom Line

Once you understand the pros and cons of home equity loans, only you can decide if it’s a good idea for you. Every loan has its benefits and drawbacks, so if you’re comfortable with a second mortgage, you may find a home equity loan to be the best borrowing option for your next project or expense.

Thinking about how you can use a home equity loan? Start the approval process today with our friends at Rocket Mortgage.