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- A home equity loan is a second mortgage that uses your home as collateral.
- Most lenders will allow you to borrow up to a combined ratio of 80% to 90% of your home's value.
- You could lose your home if you fail to make your monthly payments.
If you're considering making improvements to your home, need help paying for your child's college, or facing some other major expense, using a home equity loan could be a way to get your hands on a large sum of cash.
For many homeowners, a home equity loan could give them access to more money than any other type of loan. Plus, these loans often come with better interest rates and terms than other forms of debt, like credit cards and personal loans.
But home equity loans come with their fair share of risks, as well. Here's what you need to know about home equity loans before you start contacting lenders and filling out loan papers.
What is a home equity loan?
A home equity loan is a type of second mortgage that uses your home as collateral and allows you to borrow against your home's current value. If your home is worth $250,000 and you only owe $100,000 on your mortgage, you currently have $150,000 of "equity" in your home. And you may be able to borrow against some of that with a home equity loan.
With a home equity loan, you borrow the entire sum of money up front and then make equal monthly payments until the loan is paid back. The repayment terms on a home equity loan can range from five to 30 years and the interest rate is generally fixed.
Home equity loan vs. home equity line of credit (HELOC)
A home equity line of credit (HELOC) is similar to a home equity loan in that both types of debt involve the homeowner borrowing against their home's value. However, a HELOC operates more like a credit card. You get a credit limit that you can borrow against repeatedly for a set amount of time called the "draw period."
Once the "draw period" on a HELOC ends, the credit line will no longer be accessible to the borrower and regular payments begin. HELOC terms can vary, but they often have five- to 10-year draw periods, followed by a 10- to 20-year repayment period. Unlike a home equity loan or home improvement loan, a HELOC typically comes with a variable interest rate.
How much money can you borrow with a home equity loan?
Lenders typically require borrowers to have a maximum combined loan-to-value ratio (CLTV) between 80% and 90%. Your CLTV is the ratio of how much you've borrowed on your property relative to its total value.
You can find your CLTV by dividing the total amount you owe on any loans attached to your property by the value of your home and then multiplying by 100.
So if your home is worth $250,000, you owe $100,000 on your current mortgage, and take out a $50,000 home equity loan, your CLTV would be 60% ($150,000/$250,000 = 0.60).
To find the maximum amount you can borrow with a home equity loan, you'll need to know the maximum allowed CLTV of the lender you're borrowing from, your home's current value, and the balance of your first mortgage.
To calculate how much you can borrow, take your home's value and multiply it by the lender's maximum CLTV. Then, subtract the amount you owe on your current mortgage. The formula looks like this:
(Home value × max CLTV) − remaining first mortgage balance = maximum home equity loan amount
For example, lets say your lender allows CLTVs up to 90% and your home is worth $250,000.
$250,000 × 0.90 = $225,000
This means you could borrow up to a combined $225,000 on your home. But remember that you still owe $100,000 on your current mortgage. To find out what equity you have available for a home equity loan, subtract your current mortgage balance from this amount.
$225,000 − $100,000 = $125,000
The maximum home equity loan amount you could get in this scenario is $125,000.
Pros and cons of home equity loans
What to look for in a home equity loan
When you're comparing the best home equity loan lenders, here are a few factors you'll want to pay attention to:
- Interest rate: Is the interest rate fixed or variable?
- Terms: How many years will you have to repay the loan?
- Fees: Does the lender charge any application, origination, or appraisal fees?
- Closing costs: Will you be expected to bring any cash to the closing table? If so, how much?
While you may be tempted to focus solely on finding the lender with the lowest interest rate, the other factors listed above are important as well.
For example, if Lender A is willing to offer you a repayment term that's five years longer than Lender B, your monthly payments with Lender A could be much more affordable, even with a slightly higher interest rate.
Look out for home equity loan scams
The Federal Trade Commission (FTC) warns that there are many unethical home lenders that offer high-cost home equity loans. Many of these lenders target senior citizens or homeowners with low incomes or bad credit.
These lenders often use deceptive or unlawful tactics to take advantage of people, like "equity stripping." With equity stripping, lenders give home equity loans to homeowners who don't have the income to repay the loan — putting them at significant risk of losing their home.
If you feel like you were pressured to take out a home equity loan by an unscrupulous lender, federal law gives you up to three days to cancel the loan without penalty. Learn more about harmful home equity loan practices and your rights.
Before signing anything, be sure to read all the loan closing papers carefully. And look up lenders online to see what others are saying about the way they run their businesses. Finally, using a mortgage broker could help you find a reputable lender with the best deal.
Taking out a home equity loan could be a good option to cover an expense you might otherwise not be able to afford. But understand that if you fail to make payments on your loan, you could lose your house.
Home equity loan FAQs
What is a home equity loan, and how does it work?
A home equity loan is a type of second mortgage. Instead of refinancing a home and getting a new mortgage, you'll have both your original home loan and the home equity loan. You'll borrow against equity you've gained in the house, then make monthly payments (with interest) on the amount you owe.
What is the downside to a home equity loan?
The main downside of a home equity loan is that if you can't make monthly payments, you could face foreclosure on your house.
Is it a good idea to take equity out of your house?
It can be a good idea to take equity out of your house if it would help you reach another goal. Tapping into home equity typically involves lower interest rates than credit cards or personal loans, and you may be able to borrow more.