If you've owned a home for some time now, you know that it's more than just a piece of the American Dream. It may also be the most valuable asset you own—an asset you can leverage when you need to borrow money, either through a home equity loan or home equity line of credit (HELOC). Here is what you need to know about applying for one.
- Both home equity loans and home equity lines of credit are based on the difference between your home's current value and how much you still owe on your mortgage.
- Home equity loans tend to have lower interest rates than other borrowing options because they are secured by your home and considered less risky to lenders.
- A home equity line of credit works like a credit card, in that you have a fixed credit limit that you can borrow against when you need to and then pay back over time.
Home Equity Loans vs. HELOCs
When it comes to borrowing money, both a home equity loan and a HELOC are secured by possibly the most important piece of collateral you can offer—your home. As long as you have equity in your home, which is the difference between how much you currently owe on your mortgage and your home's current value on the market, you can tap into either a home equity loan or HELOC for a portion of that equity. Here is how the two differ:
What Is a Home Equity Loan?
Home equity loans function much like other types of loans. When approved by a lender, the borrower receives the entirety of the loan as a single lump sum. The borrower can spend the money however they see fit, such as for debt consolidation, paying emergency bills, or a home remodeling project. The borrower must then repay the loan through a series of scheduled payments. A home equity loan's term can last anywhere from 5 to 30 years.
Home equity loans have a fixed interest rate. That rate will usually be lower than the borrower could get on other kinds of loans because using the home as collateral makes the loan a safer bet for the lender.
Home equity loans are also commonly referred to as second mortgages or home equity installment loans.
What Is a Home Equity Line of Credit (HELOC)?
If home equity loans function like traditional loans, then a home equity line of credit functions similarly to a secured credit card, except that instead of money in the bank serving as collateral, the borrower's residence does.
When approved, the borrower is able to take out money through a revolving credit line. As such, the homeowner can borrow a portion of their current credit limit, spend the funds, repay those funds with interest, and then take more money out later. This allows the homeowner to access cash when it's needed rather than all at once. That might be useful, for example, if you plan to remodel your kitchen this year and add on a deck in a year or two.
Unlike a home equity loan, but similar to most credit cards, HELOCs have a variable interest rate. The rate will fluctuate over time based on market forces, the borrower's credit score, and how much they're borrowing at any given time. This results in a minimum payment that can rise or fall between scheduled payments, making HELOCs less predictable for the borrower than home equity loans.
Requirements to Apply for a Home Equity Loan or HELOC
If you know exactly how much you need to borrow and know you can repay that amount over a number of years, then a home equity loan is likely the right choice for you. However, if you're unsure how much you'll actually need to borrow or for how long you'll need to keep taking money out, then you should consider a HELOC instead.
When you've made that determination and want to move forward, there are some things you'll need to have in line before a lender will approve you. Typically, both options have similar requirements, although each lender is different and may require something that their competitors do not. Laws can also differ from state to state. These are some of the requirements you're likely to encounter:
- You'll need enough equity. First, of course, you will have to have equity to borrow against. Bear in mind that lenders won't let you borrow the full amount of your equity but will generally limit you to no more than 85% of it. So, if you've built up $50,000 in equity, you might be able to borrow as much as $42,500 if you meet all the other requirements. Note, too, that home equity loans and lines of credit typically have closing costs of several thousand dollars, so you will walk away with less than the amount you've borrowed.
- You'll need a good credit score. Prospective lenders will also expect you to have a solid credit score, which they use as an indicator of how risky lending to you is likely to be. Though lenders differ, most will want to see a credit score in the mid-600s or up before even considering your application. Obviously the higher your credit score, the better. (The highest possible credit score is 850, but anything over 670 is considered good.) The lender will also check your credit report for additional information regarding your creditworthiness, including the types of credit you have, how much you owe, how long those accounts have been open, and whether you have any late payments on your file.
- You can't have too much other debt. The lender will also consider your debt-to-income (DTI) ratio, which measures how much of your monthly income already goes to other outstanding debts. You will likely need to provide proof of income in the form of pay stubs, W-2 forms, or other relevant documents. In most cases, lenders will want to see a DTI no higher than 36%, although some may go as high as 43%. All of your monthly borrowing expenses, including your existing mortgage payment, any student loan debt, credit card bills, and other debt is added up and then divided by your monthly income to arrive at this number.
The Bottom Line
If you have equity in your home, a home equity loan or HELOC can be an easy way to tap some of that equity for other purposes. Which will work best for you basically comes down to whether you need to borrow a fixed amount now or would prefer a more flexible line of credit that you can use as needed.
Bear in mind, of course, that either a home equity loan or HELOC will put you deeper into debt, which could be a problem if you suffer a serious financial reversal due to a job loss, large medical bills, or other unforeseen events. And because these loans are secured by your home, you could conceivably lose it if you are unable to keep up with the payments.
How Much Equity Do I Need to Get a Home Equity Loan?
Most lenders will want you to have at least 15% to 20% equity in your home both before and after the home equity loan. So, for example, if your home is currently worth $300,000 and you still owe $270,000 on your mortgage, your equity is $30,000, or 10%. In that case, you most likely wouldn't qualify for a home equity loan or HELOC. If, however, you only owed $200,000 on your mortgage, you would have $100,000, or 33%, in equity, and most likely qualify.
How Can I Determine How Much Equity I Have in My Home?
To determine how much equity you have in your home, you'll need two numbers.
The first is how much you still owe on your mortgage. That number may be on your monthly mortgage statement or the mortgage amortization table provided by your lender. Or, you can simply call your lender and ask.
The second number is how much your home is currently worth. You can get a ballpark estimate by asking a local real estate agent or checking what homes comparable to yours have sold for recently. For a more precise estimate, you can hire a professional real estate appraiser.
What Are the Alternatives to a Home Equity Loan or Line of Credit?
If you're unable to obtain a home equity loan or HELOC, you may be eligible for a personal loan from a bank or other lender. These loans tend to have higher interest rates than a home equity loan or HELOC, but in the case of an unsecured personal loan, you won't be putting your home at risk.