A home equity loan is a loan in which the borrower uses the equity of their home as collateral for the loan. The value of the property determines the loan amount.
Residential property is a valuable financial investment. In addition to preserving value, homeownership also offers the opportunity to use equity with the help of a home equity loan to secure low-cost funds in the form of a second mortgage. Another way to leverage the value of your property is through a Home Equity Line of Credit (HELOC).
How Home Equity Works
Home equity loans, like home equity lines, use the equity in your home as collateral. Equity is the difference between your mortgage debt and the market value of the home. Because the loans are secured by the equity in your home, a lender can offer low-interest rates. Often, these are not much higher than those of first mortgages.
The home equity loan creates a lien on the home that reduces the actual equity but provides the owner with cash if needed. Like a revolving source of funds, similar to a credit card, it allows you to access the money at will. The home equity loan is often paid out in a lump sum with a fixed interest rate.
What to Consider Before Applying?
As with any loan, you should think about the necessity before taking it out. Loans always come with interest rates, which if avoidable is an unnecessary expense.
However, if you have decided to take out a certain loan amount on your home equity you can compare different loans on various comparison portals and pick out the best one for you. Usually, they have two sorting options to choose from: the rate and the estimated monthly payment. Sometimes you can also choose between fixed rates and variable rates. Anyhow, it is especially important to be clear about whether you even qualify for one of those loans.
Requirements for Home Equity Loan
Depending on the lender, the requirements for such a loan can vary. In general, factors like your LTV, DTI, and credit score are taken into account. You do not know what those abbreviations and phrases mean? Do not worry, we will explain it to you.
1. Loan-to-Value Ratio (LTV)
As the name might already have told you, you must have a certain percentage of equity in your home to apply for a home equity loan. On average, that is about 15 to 20 percent. Lenders use this ratio to calculate the loan-to-value ratio. This determines whether you qualify for a home equity loan.
You can easily calculate the LTV value of your property yourself. To do so, divide your current loan balance by the estimated value of your home. For example, if your loan balance is $100,000 and an appraiser estimates the value of your home at $300,000, divide the balance by the appraisal and get 0.33, or 33 percent. This is your LTV ratio. With an LTV ratio of 33 percent, you still have 67 percent equity in your home.
2. Debt-to-Income Ratio (DTI)
While not all lenders specify income requirements for their home equity loans, many will still evaluate your income to make sure you earn enough money to repay your loan. In any case, however, your debt-to-income ratio is another factor lenders consider when reviewing a home equity loan application. The lower your DTI percentage, the better. Our debt-to-income calculator will tell you your ratio.
3. Credit Score
In addition to equity, there are several other conditions that lenders tie to making a home equity loan. According to Experian, a favorable credit score in the range between 660 and 700, for example, is a requirement for many banks to approve you.
You can find both your DTI and your credit score out now with Best Egg Financial Health.
Why you Should Consider a Home Equity Loan to Renovate your Home
For larger expenses like one-time home renovations, home equity loans make perfect sense. Investing in remodeling or home upgrades to your home can be especially worthwhile for you. While you do spend money from your loan, the value of your home increases. This increase in value, in turn, has a positive impact on the loan-to-value ratio.
However, financing your home renovation project with a home equity loan has some downsides, too. As your house or apartment is used as collateral, you risk losing it when you cannot pay back the loan. In addition, equity loans are usually not the solution if you only need a small cash injection due to high closing costs.
For that, you are better off turning to traditional personal loans. Read more about the different pros and cons in our article Personal Loans 101: What You Need to Know or learn more about home renovation loans.