What is a Home Equity Loan?
If you owe less on your home than it is worth, that difference is called equity. So a loan against the equity in your home is when you put that value up as collateral or security for a new loan.
It sounds so commonplace and innocent, but it has great risks. Not all home equity products are the same. Keep reading and you’ll learn more.
How Does a Home Equity Loan Work?
Lenders are eager to make a loan to you when you have a lot of equity in your home. What they want to know is if there is truly sufficient equity to minimize their risk to make the loan.
Once it is determined by the lender that sufficient equity exists to make the loan, the lender will begin the paperwork to place a lien against the property.
This process may involve an appraiser visiting the property and generating a report regarding the property value.
A title company may be enlisted to search the legal title on the property to make sure there are no surprises that would put the new lien at risk.
A second mortgage would be drafted, the property owner would sign this legal document, funds would be distributed, and the second mortgage recorded against the property at the county courthouse.
Using Home Equity to Pay Off Debt
One of the common uses of borrowing money by pledging the equity on your home as collateral is to take the funds to pay off debt. You can use the money you borrow to either pay your other debts off in full or use the funds to settle your debt for less than you owe, as long as you understand the consequences of settling your debt.
How Much Can You Borrow on a Home Equity Loan?
Ultimately the amount you can borrow is determined by your lender. If your lender is willing to take more of a risk if the property value drops, then you may be able to borrow more of the total equity in your property, even if your income might make paying the loan back, difficult.
A more conservative lender is going to evaluate your ability to repay the new loan with your current income and leave an adequate margin between the total liens against the property and the calculated property value. That approach actually is safer for you as well.
There are many different types of lenders. Some are prudent and conservative. Others are reckless and make loans when it is less likely you can afford them. No two lenders are alike.
Ultimately the amount you can borrow is going to depend on the level of risk the lender will take if property values fall or you find yourself unable to make the monthly payments.
However, a good rule of thumb is a lender will lend up to 80 percent of the total value of the property. If your credit score is high and your credit history is strong then even conservative lenders may be willing to go as high as 95 percent of the property value.
If your home is worth $250,000 and your first mortgage value is now $175,000, you have $75,000 of total equity at that moment. To leave the 20 percent margin the lender would not want the total value of the loans against the property to be more than $200,000. That is 80 percent of $250,000. Your home equity loan would be no more than $200,000 – $175,000, or $25,000. Keep in mind the lender is probably going to charge fees and costs for making the loan and those may be paid from the loan, leaving you less.
This home equity loan calculator from Discover does a good job of giving you a general idea of how much you may be able to borrow.
Other factors that may impact the amount you can borrow include, credit score, employment history, state the property is located in, property type, and if this is a primary or secondary residence.
How to Get a Home Equity Loan
Without a doubt, the best step you can take to get a home equity loan is to know what you are getting into and get yourself super attractive for a reliable lender.
An educated consumer is always the smartest shopper for a home equity loan. A desperate consumer who needs a loan now is the most likely to get taken advantage of.
The most likely sources of where to get a home equity loan are to talk to your current mortgage lender, the bank you currently have a relationship with, do some hunting for a lender online, or pay attention to marketing or advertising offers.
Home Equity Loan Requirements
Check Your Credit
Before you start shopping for a loan it would be an incredibly smart idea for you to check all three of your major credit bureau reports for any surprises. One place to do this for free would be at AnnualCreditReport.com.
Armed with the information reported about your credit history and payment performance you can look for errors or discrepancies that can be disputed to correct and improve your score so it the most factual.
For more information on checking your credit and what you are looking for, click here.
Check Your Equity
Without a paid appraisal to determine the fair market value of your home you will have to rely on some casual sources of information to attempt to determine the value.
- Talk to a local realtor and get an idea what your home is worth. However, if the realtor thinks there may be an option to list your home for sale, sometimes there is a tendency to tell you it is worth more than it is to excite you to list your property with them.
- Use an online website like:
The online websites are somewhat helpful but the values given are not a true value determination based on recent sales of similar homes in your general area.
Ultimately the only value that counts is the one your lender accepts as the current value. They have the final say based on their process and data they elect to use to reach that conclusion.
Check Your Debt
There are three primary areas to look in to figure out how much you owe.
- You remember those three credit reports you obtained above, look at all the debt that is listed on those. Keep in mind, there is no requirement that any creditor MUST list debts you owe and so not all debts will appear on your credit report.
- Look in your mailbox or inbox for statements from creditors that give you an idea about remaining balances you may have.
- Don’t forget debts that may not be found using the advice above. These may be debts like medical bills, gym memberships, and other services you’ve contracted for that may not send you a regular statement.
How to Qualify for a Home Equity Loan
The best way to qualify for a home equity loan is to do the boring work I’ve outlined above. Just like it can take some time to get yourself ready for a special event, getting your financial outfit and knowledge all decked out is going to take a bit of effort as well.
Once you’ve looked over your credit reports, correct any errors, tallied up all your debt, and you know what your credit score is; then you are ready to go and put your best foot forward.
How to Qualify for a Home Equity Loan With Bad Credit
Just because you may have a spotted credit history or too much debt, that is not an automatic denial for a home equity loan.
Just like above, you have to get yourself ready and put your best foot forward. A poor credit score may reduce the amount of money you can borrow and make the loan more expensive than if you had pristine credit, but with enough equity, you will probably still get a loan offer.
This is primarily because lenders know even people with bad credit are less likely to miss home equity loan payments and lose their home to foreclosure. Of all the loans that you can apply for with bad credit, a home equity loan is probably the easiest to get.
What is Needed for a Home Equity Loan
Here is all the documentation you may want to get together to apply for your home equity loan:
- W2 earnings statements or 1099 DIV income statements for the last two years
- Federal tax returns for the last two years
- Bank statements for the last few months
- Recent paycheck stubs
- Proof of other income, such as tips, Social Security payments, etc.
- Proof of investment income
- Proof of homeowners insurance
- Escrow statements
- Additional documentation requested
It never seems to fail, your lender is most like going to ask you for some piece of documentation, not on the list above. It doesn’t surprise me anymore when a lender makes a strange last minute request. It seems like that’s the normal process. So don’t get discouraged. If you want the home equity loan then just gather together what they request and try to maintain a calm attitude.
How Long Does it Take to Get a Home Equity Loan
The speed at which your lender will move is dependent on three things.
- The speed of their internal processing.
- How fast you can get them the documentation they will request.
- The time it takes for outside parties like a title search company or appraiser to get their work completed.
My experience is this will take twice as long as the lender estimates and it will twice as frustrating than you expect.
Needing a quick home equity loan in a day or a week might be an unrealistic expectation. I would plan on the process taking two to three weeks, at least.
Pros and Cons of a Home Equity Loan
Pros of a Home Equity Loan
- You get access to an asset you own to use as collateral for a loan.
- You can avoid borrowing from your 401(k) and leave those funds along so they can grow for retirement.
- The interest charged on the loan will be less than on an unsecured loan.
- There may be a tax benefit to borrowing with a home equity loan. However, the restrictions below limit what home equity loans may be eligible to have their interest paid to be tax deductible.
- The money needs to be used to renovate your home, build a home, or purchase a home.
- Improvements to your home using the money will need to be “substantial improvements” that makes the home safer or more livable. Using the loan money to retrofit a home to be handicapped accessible should qualify as well. The IRS has said that doing routine maintenance like having your home repainted is not a qualifying improvement.
Cons of a Home Equity Loan
- The rule of all mortgages is “you have to pay to stay.” So if you get a home equity loan against your home and the primary mortgage payments and the new home equity loan payments become too much to afford, you may lose your home to foreclosure or have to sell it.
- Just because a lender will approve you that does not mean the loan is affordable or sustainable for you. You will need to carefully evaluate if you can make the new payments and have enough savings to cover several months of payments if you were out of work.
- There will be fees and costs for obtaining the loan. These may include money generating fees or costs passed on from outside entities like the title company and appraiser.
- Using a home equity loan to pay off other debt may soon give you the false impression you are ready to take on new debt. Some people wind up with a home equity loan and then back in debt again.
What is Better, a Home Equity Loan or Home Equity Line of Credit (HELOC)?
While a home equity loan and a home equity line of credit both use the equity in your home to qualify you for the loan, they are very different financial products.
A home equity loan is more like the original mortgage you obtained on your home.
A home equity line of credit (HELOC) is more like access to money from a credit card that puts your house at risk if you don’t repay.
The HELOC can be accessed and repaid over and over again. The interest rate may be variable and fluctuate over the time the HELOC is active.
If you are going to need to have access to incremental payments where you need a little money here and there and don’t have to borrow it all at once, a HELOC may be more of a consideration. However, if you are working on a big project and have the need for the loan already defined, like consolidating debt or adding an addition to your house, then a home equity loan may just give you more favorable rates and terms.
How to Find the Best Home Equity Loan
Everyone has the opportunity to find the best home equity loan for their needs. The process to do this will take some time, homework, research, and comparing offers.
So the ability to find the best offer is entirely up to how much work you want to invest in checking your credit reports, adding up your debt, and dealing with different lenders.
One fact is guaranteed. The best home equity loan for the lender and for you are going to be two different loans. You want to save as much money as possible and the lender wants to make as much as possible. Only you can make the best decision for you.