If you're a homeowner, you have a powerful weapon in your financial arsenal—your home's equity. Leveraging your equity by taking out a home equity loan can give you access to cash for home repairs, paying down high-interest debt, or buying a second home or investment property. But to receive the most benefit from your loan, you need to find the lowest interest rate possible. Here's how to go about it.
- Home equity loans are secured by the equity you've built in your primary residence.
- Interest rates are generally based on the Federal Reserve's prime rate but can vary from lender to lender.
- Shopping around can yield the best interest rates and terms for your home equity loan.
- Improving your credit may get you a better rate.
What Is a Home Equity Loan?
A home equity loan is a loan secured by the equity in your home. Unlike a home equity line of credit (HELOC), home equity loans typically take the form of a lump sum that you pay back on a fixed repayment schedule of anywhere between five and 30 years.
When you apply for a home equity loan, lenders will consider your credit score, debt-to-income ratio, and, of course, the amount of equity you've accumulated in your current residence. Home equity loans are subject to the same kinds of closing costs as regular mortgages, such as origination fees, recording fees, and appraisals. Once you're approved for a loan, you can use the proceeds for any purpose you wish.
While home equity loans have considerably lower interest rates than credit cards, for example, their rates are usually higher than regular mortgage rates. That's because home equity loans are slightly riskier for the lender. If you default on your home loans and the property goes into foreclosure, your primary mortgage will be paid back first and the proceeds from the foreclosure could be exhausted before your home equity loan is satisfied.
What Determines Your Home Equity Loan's Interest Rate?
Several factors affect home equity loan interest rates. Most lenders base their annual percentage rate (APR) on the prime rate set by the Federal Reserve, to which they add their own markup or margin. In deciding on a rate to offer you, they will also consider your specific situation. That can include your:
- Debt-to-income (DTI) ratio: Most lenders want to see a DTI of less than 43%. This shows you're not overextended.
- Credit score: Aim for a credit score of 700 or above. This demonstrates a history of responsible payments and low credit utilization. The higher your credit score, the better the rate you'll likely be offered.
- Loan-to-value (LTV) ratio: This shows how much you owe on your primary mortgage relative to how much your home is worth. If you have more than one loan, lenders will look at your combined LTV. You can calculate your LTV by dividing your current loan balance by your home's appraised value.
If you decide on a lender and have second thoughts, you can cancel your transaction within three business days of signing the paperwork. If another lender comes up with a more attractive offer in the ninth hour, this can be a valuable tool.
How To Get the Best Rate
It may sound simple, but the best way to get the best rate is to compare several lenders. Although lenders generally base their annual percentage rate (APR) on the prime rate, many other factors, including individual lender fees, are baked into the final APR. So the APR is the number you want to focus on.
If you currently have a mortgage, starting with your current lender may be wise. Many banks or other lenders offer loyalty discounts to current clients to keep their business. This might be in the form of a lower interest rate or eliminating some of your closing costs, such as appraisal or application fees.
Beyond your current lender, plan to talk to at least three different lenders. Comparison shopping may take a bit more time but can result in a better rate or better terms. Let each lender know that you're shopping around and allow them to compete for the best terms and interest rates.
Just make sure that you're comparing apples to apples. If you're looking for a specific loan term length, ask about the same term from all lenders. Sometimes loans with different term lengths will have different interest rates. But bear in mind that a longer term at a lower interest rate may still cost you more money in the long run.
Am I Required To Disclose That I Am Working With Multiple Lenders?
You're not required to disclose this information but doing so may give the lenders an incentive to offer you their most attractive rates.
Do I Have To Have My House Appraised for a Home Equity Loan?
Most often, yes. Since your equity is determined by your home's current value, it's essential for the lender to know the property's worth. In some cases, lenders may waive the appraisal if the home's value can be determined through comparable home sales in the area or other, very recent appraisals. If the lender does require an appraisal, it will usually arrange for it and pick the appraiser. You, however, will generally have to pay the appraiser's fee.
Is the Interest on a Home Equity Loan Tax-Deductible?
That depends on what you use the money for. Under current law, the interest is deductible only if the loan proceeds are used to "buy, build or substantially improve the taxpayer’s home that secures the loan," the Internal Revenue Service says.
The Bottom Line
The interest rate is one of the most important features to look for in a home equity loan and rates can vary from one lender to another. Talking to several lenders is the best way to find the best rate. Increasing your credit score and lowering your debt-to-income (DTI) ratio will also make you more attractive to lenders, often resulting in a lower rate.