Leverage home equity without refinancing
A home equity loan is a type of loan that lets you borrow against your home’s cash value, often at a low fixed interest rate. As a “second mortgage,” a home equity loan is typically a smaller, second loan taken out in addition to your existing mortgage. This lets you tap your home’s value without changing the rate or terms on your primary mortgage. You can also take out a home equity loan if your home is fully paid off and borrow only the amount you want to cash out.
A home equity loan is a popular way to unlock your home’s equity without selling or refinancing the property.
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What is a home equity loan?
A home equity loan is a type of mortgage that’s secured by your home equity. Equity is the difference between your home’s value and what you owe the mortgage company. If you owe your mortgage lender $100,000 and your property appraises for $250,000, you have $150,000 in equity.
Unlike a cash-out refinance, a home equity loan is used for the sole purpose of borrowing cash. It does not refinance your existing mortgage balance or change the rate and term on your primary mortgage. Rather, it’s a separate loan with its own interest rate and monthly payment. That’s why a home equity loan is known as a “second mortgage.”
Smart uses for a home equity loan include debt consolidation, home improvements, paying for college, and starting a business. These types of loans aren’t typically recommended for luxury items, vacations, or risky real estate investments.
How does a home equity loan work?
A home equity loan is a lump sum installment loan. This means you’ll receive the entire loan amount upfront and pay it off in equal monthly installments, until the balance is zeroed out.
Home equity loans work a lot like standard home loans. They typically have fixed rates and fixed monthly payments, with loan terms ranging from 10 to 30 years. You can deduct interest paid on a home equity loan, but only when using funds to buy or build a property or “substantially improve” a property you already own.
Home equity loans differ from home equity lines of credit (HELOCs), which allow borrowers to access a line of credit on an as-needed basis. They’re also different from cash-out refinancing, which replaces an existing mortgage with a new one.
Since you’re taking another loan against the property, home equity loans are also known as second mortgages. Your primary mortgage remains as the “first lien,” and your second mortgage is the “junior lien.” If you sell the home before repaying a home equity loan, you’ll pay off the balance with proceeds from the sale.
Home equity loans can be attractive options because they typically have lower interest rates compared to other types of debt, like credit cards and personal loans. But since your home acts as collateral, missing loan payments could result in foreclosure.
How much of a home equity loan can I get?
The amount of money you can borrow with a home equity loan depends on how much equity you’ve built up in your home and what you own on your primary mortgage. Most lenders cap your combined loan-to-value ratio (CLTV) around 80%. This means that your primary mortgage and your home equity loan together can’t be more than 80% of the home’s value.
For example, say your home appraises for $400,000. But you currently owe $150,000 on your primary mortgage. Here’s how to find your maximum home equity loan amount:
- Home value: $400,000
- Maximum combined loan amount: $320,000 (80% of value)
- Existing mortgage balance: $150,000
- Maximum home equity loan: $170,000 (maximum CLTV minus existing mortgage)
The amount you can borrow also depends on your credit score, interest rate, and debt-to-income ratio (DTI).
When it comes to DTI, your lender will review your monthly loan and credit card payments. They then compare this figure with your income to determine affordability. For this reason, two borrowers with similar incomes and the same amount of equity can qualify for different size home equity loans — especially if one borrower has more debt than the other.
Home equity loan requirements
Just having a lot of equity doesn’t necessarily qualify someone for a second mortgage. Home equity loan requirements differ from one lender to the next, but they typically include:
- More than 20% equity in the home
- A loan-to-value ratio (LTV) of 80% to 85%
- A debt-to-income ratio of 43% or lower
- Meet the lender’s minimum credit score requirement
- Proof of income or an ability to repay
Credit score requirements for a home equity loan vary heavily by lender. Some lenders allow credit scores as low as 620, whereas others require a score in the mid-600s or higher.
If you have a lower score, you’ll need to shop around and compare lenders. It might be easier to qualify if you have compensating factors, such as low debts or extensive assets.
Do home equity loans have closing costs?
Many home equity loans have closing costs, but not all. Whether or not you pay any will depend on your lender. For example, Regions Bank does not charge closing costs. However, borrowers will need to pay for items such as prepaid interest, any state or federal taxes, and title insurance.
Still, Frost Bank claims you won’t pay any fees on home equity loans under $500,000, including closing costs, annual fees, or prepayment penalties. Keep in mind that loans without closing costs often charge higher interest rates.
On the other hand, you’ll likely pay closing costs between 2% to 5% of the loan amount with traditional lenders like US Bank or Connexus Credit Union.
Be sure to read your loan disclosures carefully when evaluating whether or not this type of solution is right for your financial situation.
Costs of a home equity loan
Your lender may require you to pay all or some of the costs associated with underwriting a home equity loan. These fees will vary from one lender to another, but here are a few you will likely see.
- Origination fee: Upfront fee to cover the administration costs of underwriting a loan
- Appraisal fee: Having a home appraiser determine the value of your home. This is a third-party fee that is usually non-negotiable
- Closing costs: Fees for pulling credit reports and document preparation, to name a few
- Title fees: Costs for title search and/or title insurance
- Prepayment penalty: Fees charged for paying your loan balance in full too early
- Annual fee: A yearly cost to keep your loan with a lender
You may even be required to pay for additional items like flood insurance, depending on your state of residence and the location of your home. Be sure to speak with your loan officer to fully understand all of the costs that come with a new home equity loan.
Home equity loan pros and cons
Home equity loans are often well suited for homeowners who know the amount of money they’ll need for home renovations. But before you decide on whether or not to get one, evaluate the pros and cons of home equity loans.
Pros
- Generally easier to qualify for than a cash-out refinance or other home loans
- Fixed interest rates and monthly payments
- Few rules about how to use funds
Cons
- Your home is used as collateral for the loan. This means you risk foreclosure if you default on the loan
- You’ll pay two monthly payments unless you own your home outright
- Loan balance must be paid in full if you sell your home
If you’re concerned about needing additional funds for your home improvements, a HELOC may be a better option for your needs.
Home equity loans vs. HELOCs
Home equity loans issue an individual lump-sum payment that is repaid over a period of time. You’ll pay interest on the loan at a fixed rate. So the monthly payments never change. However, if you sell the home before the loan term concludes, repayment is usually required in full.
Alternatively, HELOCs are a revolving credit line. Rather than an upfront lump sum of cash, HELOCs allow you access to a pre-approved credit limit that is based on the value of your home. You can repay any money you’ve borrowed, and reuse the HELOC as often as you like during its draw period.
A HELOC’s draw period is typically between five to 20 years, with a 10-year term being most common. Following the draw period is the “repayment period” when you are no longer allowed to withdraw funds. Most HELOCs charge a variable interest rate, but some lenders offer them as fixed-rate loans.
How to get a home equity loan
In many ways, the requirements for a home equity loan are the same as those for a primary mortgage. But because you won’t be borrowing the entire cost of a home, there are a few important differences. Here are seven steps to apply for a home equity loan.
1. Review your finances
A home equity loan adds to your monthly debt, so review your financial situation to see if you can handle the additional payment. Also, review your credit report and credit score. You typically need a minimum 620 credit score to qualify. Paying your bills on time, paying down credit cards, and disputing errors on your credit report can raise your score.
2. Determine how much to borrow
Your lender ultimately decides the amount of money you can borrow against your equity. Even so, have a figure in mind so that you don’t borrow more than necessary. Think about how much cash you need for home renovations or to accomplish a financial goal. Also pre-determine what monthly payment you’re comfortable with — especially if you’re still paying down your first mortgage.
3. Gather your paperwork
You’ll need to submit supporting documentation such as paycheck stubs, tax returns, W-2s, and bank statements. Lenders use this information to calculate your debt-to-income ratio and creditworthiness. Having your paperwork ahead of time will help your application get approved more quickly.
4. Compare home equity loan lenders
Home equity loan requirements and terms can vary by lender. Get a minimum of three quotes from different lenders and then compare rates, origination fees, terms, and credit score requirements. You can get a quote from your current lender as well as other banks, credit unions, mortgage companies, and online lenders.
5. Go through the underwriting process
Your lender will carefully review your income statements, bank statements, credit history, and debts to see if you qualify for a home equity loan and determine how much you can borrow.
6. Wait for the appraisal
Your mortgage lender will order a home appraisal to assess your home’s market value. This is required before approving your application.
7. Close on the loan
Once your lender completes the underwriting process and receives the appraisal report, the final step is closing. You’ll sign the loan paperwork and receive the lump sum payment.
After closing on a home equity loan, you’ll begin making regular monthly payments. If you currently have a mortgage loan, your home equity loan will be a second payment on top of your regular mortgage payment. If your home was paid off, you’ll pay only the home equity loan.
Home equity loan FAQ
A home equity loan is a type of mortgage loan. It isn’t a primary mortgage, like the one you use to buy a home, but rather a secondary mortgage secured by the property. This junior lien is also called a second mortgage. Since your property serves as collateral for a home equity loan, not repaying the loan could result in foreclosure.
On average, it can take between two weeks and six weeks to close on a home equity loan. But initial loan approval can occur within several business days. The process of getting a home equity loan can vary from lender to lender. Factors that influence the timeline include a lender’s underwriting process, appraiser schedules, scheduling conflicts, and delays with submitting documentation.
Home equity loans usually have higher interest rates than standard home loans. However, they tend to be substantially lower than other, unsecured forms of borrowing like credit cards and personal loans. Home equity loan rates are fixed, meaning your interest rate and payment will stay the same throughout the loan term. Furthermore, the rate you’ll pay is based on the prime rate. But items such as your creditworthiness, loan-to-value ratio (LTV), and lender will also affect the rate you’re offered.
Home equity loans are only tax-deductible under special circumstances. Currently, you can deduct interest on a home equity loan only when using the funds to buy or build a primary residence or second home, or when using funds to substantially improve a primary residence or second home. As of 2022, married couples filing jointly can deduct interest on up to $750,000 of mortgage debt, and married couples filing separately can deduct interest on up to $375,000 of mortgage debt. But you should always check with a tax advisor before making any decisions that could impact your annual tax filings.
Most lenders require a minimum credit score in the mid- to high-600s for a home equity loan, but it may be possible to get approved with a lower score. Some lenders will approve homeowners with scores as low as 620. However, you’ll need to shop around to find these lenders. It’s easier to get approved with bad credit when you have compensating factors. This includes stable income and little consumer debt.
Home equity loans are widely available, and many types of lenders offer this option. These include banks, credit unions, mortgage companies, and online lenders. To get started, contact your current mortgage lender and your bank or credit union. Compare their rates, terms, and requirements. Get at least three rate quotes before choosing a lender.
Find out if you qualify for a home equity loan
If you meet the basic requirements for a home equity loan, you stand a good chance for approval. But you’ll need to reach out to a lender to know for sure.
If you’re ready to get started, check home equity loan rates with a few different lenders to find the most affordable option for you.
