How do home equity loans work?

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• A home equity loan allows a homeowner with significant equity to borrow a large sum of money. 
• Lenders look at your credit history, debt, income, and the market value of your home to decide how much you can borrow. 
• The major risk of a home equity loan is that you could lose your home if you're unable to make payments.

There are several ways to tap your home for cash, and one of the most popular is taking out a home equity loan.

Home equity loans are often used to pay for things like home renovations or an unexpected emergencies, and can be cheaper than carrying a balance on a credit card or personal loan. The tradeoff is that your home is on the line. If you fail to make payments on a home equity loan, your lender can foreclose.  

What is a home equity loan?

A home equity loan is a fixed-rate loan that allows you to turn the equity in your home into cash. Also called a second mortgage, a home equity loan is distributed in a lump-sum payment and has a set repayment period, making the loan ideal for someone who knows how much they need to borrow and wants predictability in paying it back. 

"Home equity loans are best suited for those that have an essential expense that's large (debt consolidation, home improvements, medical bills, etc.), who have equity in their home and good credit, and are looking for a loan with low interest," says Andrew Rosen, a CFP® professional and president of financial planning firm Diversified. "Home equity loans aren't for you if you don't have equity built up in your home, or if you're not comfortable putting your home up as collateral for the loan."

To qualify for a home equity loan, there are several factors that must be in place for it to make sense. These include your credit score, debt-to-income (DTI) ratio, and most importantly the amount of equity you have in your home. 

• Credit score. For the best terms on a home equity loan, you'll want a high credit score. Lenders look for a credit score above 680, but a score of 740 or higher will help you qualify for the best rates.
• Debt-to-income ratio. On a home equity loan, lenders look for a DTI ratio of 43% or lower. This is the total amount of monthly debt divided by the amount of income you earn each month. This ratio will include the amount of the home equity loan borrowers apply for. 
• Home equity. The amount you're able to borrow depends on what the lender is willing to lend, but generally maxes out at 80% to 85% of your home's value. That means the new home equity loan plus your first mortgage cannot exceed 80% to 85% of the market value of your home. 

To help determine if a home equity loan makes sense, we'll walk you through the steps of calculating the amount of equity you have in your home, how to estimate your maximum loan amount, how to get the best rates, and what to look for in a loan.

How do home equity loans work?

A home equity loan works similarly to other loans. You'll get approved for the loan, receive the money, and repay the principal plus interest in fixed installments (on top of your primary mortgage payments). A difference from, say, a personal loan is that a home equity loan is secured by your house, resulting in a lower interest rate, since there's less risk to the lender. And the amount you borrow is based on your home's value and equity, not solely on your credit score or income.

To start the process of qualifying for a home equity loan, you may first want to estimate how much you can borrow on a home equity loan. 

1. Find out how much you can borrow

During the loan approval process, the lender will hire an independent appraiser to determine how much your home is worth. This appraisal will affect how much you'll be able to borrow. Before that happens, you may want to estimate this number for yourself. 

Let's say your home's market value is $500,000 and you owe $200,000 on your mortgage. To figure out how much you can borrow against it, first multiply the market value by 85%. That works out to be $425,000. Then subtract the $200,000 you still owe on it, and you arrive at your maximum loan amount: $225,000.

However, your loan amount is also dependent on your credit history and ability to repay the loan. Though you may have a maximum loan amount of $225,000 based on your equity, the lender will approve a lower amount if you don't have enough income, your debts are too high, or your credit score is lower.

2. Apply for a loan

Your home equity loan provider can be different from your primary mortgage provider. You'll want to shop around for a lender much like you did when you applied for your primary mortgage to get the best rates and loan terms. 

"When comparing lenders, understand the repayment policies in terms of early repayment and prepayment penalties," says Dennis Shirshikov, strategist at Awning.com, a real-estate investment platform. "Also shop around for rates aggressively, every lender essentially offers the same product and service and a 0.5% interest rate difference can translate into over $10,000 in interest."

Some features to look at closely on a home equity loan:

• Interest rates. The interest rate you qualify for will depend on your credit score and your lender. Because you secure the loan with your home, you'll pay a lower interest rate on a home equity loan than you would on a personal loan. While credit scores above 740 may qualify you for the best rates, you may also be able to qualify for a home equity loan with a credit score as low as 680. 
• Fees and closing costs. Every lender should provide you with a fee estimate for the loan. These can vary widely among lenders. There are even some options on the market for a no-closing-cost home equity loan.
• Repayment period. Repayment periods can be anywhere between five and 30 years, depending on your lender, what you qualify for, and your personal preference. 
• Repayment structure. Understand your options for making payments. For example, a balloon payment is a large payment due at the end of the loan. If you're unable to make this payment, you'll have to get another loan or default. These are more common for interest-only loans.
• Penalties. What's the late fee? Is there a prepayment penalty for paying off the loan early? Be sure you know the conditions of the loan you're agreeing to. 

3. Receive a lump sum

A home equity loan takes longer to process than the typical personal loan. Lenders usually require a new appraisal for the home and underwriters will look closely at the amount you want to borrow relative to the current market value of your home. 

The amount of time it takes to get a home equity loan after you're approved and have signed the closing documents depends on the lender. In general, you can expect to close the loan in about a month. Once you receive the money in your bank account, you can spend it on virtually anything you want. 

4. Start repayments

Shortly after you close on the loan — likely the next billing cycle — you'll start repayments. When a home equity loan has a fixed interest rate, you'll know exactly what your payments are going to be every month for the life of the loan.

Pros and cons of a home equity loan

While a home equity loan allows a homeowner to borrow a large sum at a low interest rate, there are plenty of situations where a home equity loan doesn't make sense, so be sure to evaluate the pros and cons in the context of your own financial situation.

Pros

• Lower interest rate. Consumers pay lower interest rates on these types of loans because they're secured by a large asset. 
• Fixed payment. Home equity loans most often have fixed interest rates, which means the monthly payment stays the same until the balance is paid off. A variable rate would make monthly payments unpredictable.
• Lump-sum loan. With a home equity loan, you receive the entire amount of the loan up front. If you have a large expense, such as a home renovation, this can help get the project going quickly. 

Cons

• Your home is collateral. While paying a lower interest rate is great, the major drawback is that you use your home to secure the loan. This means the bank can foreclose if you fail to make your monthly payments in 90 days. 
• Not as flexible as a HELOC. A home equity loan is also not as flexible as some other borrowing options, such as a home equity line of credit (HELOC) or a credit card. You get an upfront payment with a home equity loan, not an open line of credit you can return to again and again until your limit is reached. If you have unexpected costs come up on a home renovation, for example, you won't have the flexibility to pull more money out on a home equity loan.
• Closing costs. With a home equity loan, you're likely to see some closing costs. Some lenders may offer a no-closing-cost loan, but you may pay a higher interest rate or the closing costs will be folded into your loan principal.

The bottom line

A home equity loan is a useful financial tool that can help you pay for a large expense at a lower cost than using a credit card. You may be eligible to borrow more if you have a lot of equity in your home, but it will ultimately depend on your credit score and other financial factors. Before you commit to a loan that puts your home up as collateral, be sure of your ability to pay the loan back.