If you’ve owned a home for a long time, you know it’s more than just a slice of the American Dream. It can also be the most valuable asset you own – an asset that you can use when you need to borrow money, either through a home equity loan or a home equity line of credit (HELOC). Here’s what you need to know about applying.
The central theses
- Both home equity loans and home equity lines of credit are based on the difference between the current value of your home and the amount of your mortgage debt.
- Home loans typically have lower interest rates than other loan options because they are backed by your home and are considered less risky by lenders.
- A home equity line of credit works like a credit card in that you have a fixed credit limit that you can borrow when needed and then repay over time.
Home Loans vs. HELOCs
When it comes to borrowing, both a home equity loan and a HELOC are backed by perhaps the most important security you can offer – your home. As long as you have equity in your home, which is the difference between the size of your mortgage debt and the current market value of your home, you can use either a home equity loan or HELOC for some of that equity. This is how the two differ:
What is a Home Equity Loan?
Home loans work similarly to other types of loans. Once approved by a lender, the borrower receives the entire loan in a single lump sum. The money can be used at the discretion of the borrower, e.g. B. for debt consolidation, paying emergency bills, or a home remodeling project. The borrower then has to repay the loan through a series of scheduled payments. The duration of a home loan can be anywhere from five to 30 years.
Home loans have a fixed rate of interest. This interest rate will typically be lower than the borrower could get on other types of credit, as using the home as collateral makes the loan a safer bet for the lender.
Home equity loans are also often referred to as second mortgages or home equity installment loans.
What is a Home Equity Line of Credit (HELOC)?
If home equity loans work like a traditional loan, a home equity line of credit works similarly to a secured credit card, except that instead of having money in the bank to serve as collateral, the borrower’s place of residence does.
Once approved, the borrower can borrow money through a revolving line of credit. This allows the homeowner to borrow part of their current credit limit, use the funds, repay those funds with interest, and withdraw more money later. This way, the homeowner can access cash when needed, rather than all at once. This can be useful, for example, if you plan to remodel your kitchen this year and add a patio in a year or two.
Unlike a home equity loan, but similar to most credit cards, HELOCs have a floating rate. The interest rate will fluctuate over time based on market forces, the creditworthiness of the borrower, and the amount of borrowing. This results in a minimum payment that can rise or fall between scheduled payments, making HELOCs less predictable to the borrower than a home equity loan.
Requirements for applying for a home equity loan or HELOC
If you know exactly how much to borrow and you know you can repay that amount over several years, then a home loan is probably the right choice for you. However, if you are unsure of how much to actually borrow or how long to withdraw funds, consider a HELOC instead.
Once you have made that decision and are ready to move forward, there are a few things you need to consider before a lender approves you. Usually, both options have similar requirements, although each lender is different and may require something that its competitors don’t. Laws can also differ from state to state. These are some of the requirements you are likely to encounter:
- You need enough equity. First, of course, you need to have equity to borrow against. Remember, lenders will not let you borrow the full amount of your equity, but generally limit you to no more than 85% of it. So, once you’ve built up $ 50,000 in equity, you may be able to borrow up to $ 42,500 if you meet all of the other requirements. Also, be aware that home equity loans and lines of credit typically have closing costs in the thousands of dollars, so you walk away with less than the amount you borrowed.
- You need a good credit rating. Potential lenders also expect you to get one solid credit they use as an indicator of how risky it is to lend to you. While lenders vary, most will want to see a credit score in the mid-600s or higher before even considering your application. The higher your credit rating, the better. (The highest possible credit score is 850, but anything above 670 is considered good.) The lender also checks your credit report for additional information about your credit history, including the types of credit you have, how much you owe, how long those accounts have been open and whether there are any late payments in your file.
- You can’t have too many other debts. The lender will also consider your debt-to-income ratio (DTI), which measures how much of your monthly income is already being used on other outstanding debts. You will likely need to provide proof of income in the form of pay slips, W-2 forms, or other relevant documents. For the most part, lenders want to see a DTI no greater than 36%, although some can go as high as 43%. All of your monthly borrowing costs, including your existing mortgage payment, any student loan debt, credit card bills, and other debts, are added together and then divided by your monthly income to get that number.
The bottom line
If you have equity in your home, a home equity loan or HELOC can be an easy way to use some of that equity for other purposes. Which is best for you largely depends on whether you need to borrow a fixed amount now or prefer a more flexible line of credit that you can use as needed.
Of course, keep in mind that either a home loan or HELOC will put you deeper in debt, which could be a problem if you experience serious financial reversals due to job loss, high medical bills, or other unforeseen events. And since these loans are backed by your home, you could potentially lose it if you can no longer make the payments.
How Much Equity Do I Need to Get a Home Loan?
Most lenders want you to have at least 15 to 20% equity in your home before and after the home loan. 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 would most likely not qualify for a home loan or HELOC. However, if you only owe $ 200,000 on your mortgage, you have $ 100,000, or 33% equity, and you are most likely qualified.
How can I tell how much equity I have in my home?
To determine how much equity you have in your home, you need two numbers.
The first is how much do you still owe on your mortgage. This number can be on your monthly mortgage statement or on the mortgage amortization table provided by your lender. Or just call your lender and inquire.
The second number is how much your home is currently worth. You can get an estimate by asking a local real estate agent or by checking which houses similar to yours have been sold recently. For a more accurate estimate, you can hire a professional real estate appraiser.
What are the alternatives to a home equity loan or line of credit?
If you are unable to get a home loan or HELOC, you may be eligible for a personal loan from a bank or other lender. These loans usually have higher interest rates than a home loan or HELOC, but in the case of an unsecured personal loan, you are not putting your home at risk.