A home equity loan, also known as a second mortgage, allows you to borrow against the equity in your home and uses your property to secure the loan. You get a lump sum, and the loan typically has a fixed interest rate and a repayment term of five to 30 years.
Equity is the market value of your home minus what you owe on your mortgage. Lenders may want you to keep your borrowing to 80% of your home’s equity at the most, according to the Federal Trade Commission. That means if you have $100,000 in equity, you may be able to borrow $80,000. But you can find lenders that let you borrow 85% of your home’s equity, or even more.
- You’ll pay a fixed interest rate. Whether interest rates rise or fall, your monthly payment on a home equity loan will remain the same.
- You’ll pay lower interest rates than on personal loans or credit cards. That’s because your home acts as collateral for the loan.
- Your interest payments may be tax deductible. If you “buy, build or substantially improve” the home that secures a mortgage loan, according to the IRS, you may qualify to deduct your interest payments.
- You will receive one lump sum. This gives you flexibility to cover large expenses and repay over a fixed term in equal monthly installments. You can use the money for almost any purpose, such as renovating a kitchen or paying for a wedding.
- You’ll pay interest on the entire loan amount, even if you are using the money incrementally. An example is during a home renovation.
- You may have less flexibility compared with a home equity line of credit. That’s because you can draw from a HELOC as needed up to your credit limit, and a home equity loan is one lump sum.
- You could pay higher interest rates than you would for a HELOC. That’s because your rate is fixed with a home equity loan, while the rate on a HELOC will fluctuate with market conditions.
- You’ll have to juggle two mortgage payments. If you’re still paying your first mortgage, make sure you can afford the second mortgage payment on top of your other monthly expenses.
- You risk foreclosure if you fall behind on payments, as with any loan secured by your home.
The best home equity loan for you is one you can get approved for at the best rate with terms you can manage. Here are some factors to compare among home equity lenders:
- Eligibility requirements. Research a lender’s minimum credit score and debt-to-income ratio criteria, and check whether you meet them. If you do, see if you can prequalify for a home equity loan to get a rate quote.
- Loan limits. Decide how much you need to borrow. If you can’t get a big enough loan or you want to borrow less than the lender’s minimum loan amount, you will need to choose another lender.
- Interest rates. Try to choose a home equity loan with the lowest possible rate.
- Fees. Closing costs can amount to 2% to 5% of your loan, and you may have to pay other fees. Still, don’t let fees alone be the deciding factor. A lender that charges closing costs but a low rate may cost less in the long run than the opposite.
- Customer satisfaction. Check reviews at the Better Business Bureau and consumer complaints at the Consumer Financial Protection Bureau.
A home equity loan and a HELOC are alike in that they are secured by your home, the money can be used however you want and the amount you can borrow may be limited to 80% to 85% of your home equity. But there are also distinct differences.
- Have a fixed interest rate and monthly payment, with a repayment schedule of five to 30 years.
- Provide the borrower a lump sum amount.
- Allow you to withdraw money as needed up to your credit limit, similar to a credit card.
- Charge a variable interest rate, meaning your monthly payments can fluctuate.
- Provide a borrowing period, or draw period, for you to reuse and repay the credit line. The draw period can last 10 years, though it depends on your loan.
- Require at least interest payments during the draw period.
- Can offer repayment plans after the draw period, or you may be able to renew or refinance the HELOC. Repayment plans typically let you repay the loan balance over 20 years, according to Experian.
You will want to look at HELOCs and home equity loans and work with your lender to make the right choice. Both have pros and cons, including the risk of foreclosure if you fail to pay.
The average rate for a $30,000 HELOC is at 10.08% as of Dec. 13. This average is based on a 30-year term, a 80% loan-to-value ratio and a 700 FICO score.
This analysis is powered by Bankrate, which gathers data from applicants who prequalify for HELOCs through its website and affiliates.
Even though a home equity loan or a HELOC can be a great way to borrow money, it may not be the right fit for everyone. Compare home equity loans to these alternatives:
- Cash-out refinancing. A cash-out refinance is when you take out a new home loan for more money than what you owe on your original loan and receive the difference in cash.
- Reverse mortgage. A reverse mortgage is a loan for homeowners 62 and older to convert home equity into cash that can supplement retirement income.
- Personal loan. A personal loan allows you to borrow money for just about anything and pay it back in fixed amounts.
- Debt consolidation loan. A debt consolidation loan combines several high-interest debts into a new loan that can streamline your payments and may reduce your interest charges.
A home equity loan or HELOC can be worthwhile in certain situations, but homeowners should generally try to protect their equity. Home equity loans or HELOCs should not be used for purchases you otherwise couldn’t afford and don’t really need, or you end up putting your house on the line to take a vacation or buy a car.
These types of loans can be a good idea when you use them for improvements that increase your home’s value or in a true financial emergency.
A home equity loan or a HELOC can offer lower interest rates compared with credit cards and personal loans. You’ll need to be certain that you can make the payments, however.
HELOCs may be a bad idea if you can’t afford a rate increase or manage the upfront costs. Before you borrow, know how much your rate might adjust and figure out how much of an increase you can handle.
Think about your spending habits and whether a home equity loan or HELOC could help or hurt your finances. You may be better off keeping debt on your credit cards and not touching your home equity.
Once you’ve decided a home equity loan is the right choice for you, you can take the following steps to get through the application process:
- Make sure you meet minimum requirements. To get a home equity loan, you’ll generally need to have at least 15% to 20% equity in your home, according to the credit bureau Experian. Lenders also have minimum credit score requirements, and you’ll want a debt-to-income ratio no higher than 43%, Experian says.
- Gather important documents. When you apply for a home equity loan, you will need to provide personal and financial information. This may include W-2 tax forms and photo identification.
- Compare lenders. It’s a good idea to consider multiple financing options before making a decision. You’ll want to compare things like annual percentage rate, monthly payments and closing costs.
- Submit an application. Many lenders offer online applications. Check to see what options are available.
- Await a home appraisal. The lender will want to verify the value of the house you’re using as collateral, according to Rocket Mortgage.
After the lender reviews your application materials, it will let you know if you’re approved. You’ll sign the loan when you close. If your primary residence is the collateral for the loan, you can typically cancel it with no penalty within three days.
Your credit history, income and home value will determine your interest rate on a home equity loan, according to the FTC. Rates also depend on larger economic conditions that are outside your control, such as the federal funds rate. Still, you’ll want to find ways to improve your credit score and lower your debt-to-income ratio to qualify for the lowest home equity rates available.
To recap, here are the picks: