Need some extra cash to help cover your kid’s tuition? What about that unexpected home repair or medical bill? Need to cover emergency expenses or pay off a large amount of credit card debt? Consider taking out a home equity loan.
A home equity loan allows a borrower to put up his house as collateral. The loan amount is determined by the value of the home, which is set by an appraiser. Although home equity loans can be useful, remember, they reduce your home equity and can be a debt trap. Fail to repay, and your lender could foreclose on your home. Decide if tapping into your house is the right move by getting a handle on the basics of home equity loans with this guide.
Pros and Cons of Home Equity Loans
Quick and easy closing compared with mortgages, although you still might need an appraisal and title work.
Tax deductibility. The IRS might allow you to deduct the interest you pay on your home equity debt.
A low-cost alternative to credit cards. Home equity loans offer lower interest rates and can be much cheaper.
Rates are higher than on mortgages.
This risk of foreclosure. Fail to repay, and your lender can take your house.
Difficulty qualifying. You’ll need stellar credit and plenty of equity to get a loan.
Determining How Much Equity You Have
How do you know how much equity you have? It’s an inexact science, but you should be able to find an answer that’s close enough. First, you need to know how much you owe on your mortgage. If you receive monthly statements from your lender or servicer, this figure should be updated every month. If not, contact your loan servicer and inquire about your balance. Next comes the slightly trickier part: You need to know how much your home is worth. You could spend several hundred dollars for a full appraisal, but there’s an easier way to find an estimate. Zillow.com and Redfin.com both offer so-called automated valuation models.
Redfin says its estimates for homes not on the market typically land within 6 percent of the actual value. Another reliable estimate comes from your local property appraiser, a public official who estimates your home’s value for the purposes of collecting property taxes. Bear in mind, though, that these values can be a little quirky, with many property appraisers aiming for a market value that’s somewhere below full value. And they’re usually updated once a year, so they don’t capture swings throughout the year. If you’re still in doubt about your home’s value, you might check in with the Realtor or loan officer you worked with when you bought.
A Step-By-Step Guide to Calculating Your Equity
Check with your mortgage servicer to determine the amount. If you don’t receive a monthly statement by mail or e-mail, you’ll need to make a phone call.
Check with your real estate agent to get an idea of recent sales and how much your house might be worth. Also type your address into the valuation tools on Zillow.com and Redfin.com. If you want a full appraisal, you’ll have to pay for it.
Your equity is equal to the difference between your home’s value and your mortgage balance. Say your research shows your house is worth $250,000 and you owe $150,000. Congratulations: You have $100,000 in equity and plenty of cushion for a home equity loan.
If your new loan requires an appraisal, take some quick housekeeping measures such as trimming overgrown trees, pressure cleaning the driveway and painting over water damage.
Understanding Home Equity Loans
With a home equity loan, you borrow a fixed sum of money that’s secured by your home. The bank lends you the cash, and you repay it in monthly payments. Home equity loan rates are typically fixed.
There also are home equity lines of credit (HELOCs), which work more like credit cards and have variable rates. You’re approved for a certain amount of money and can borrow up to that amount by writing a check or using a credit card connected to the account. They can also be interest-only loans, so making the minimum payment means you’re repaying only the interest but not paying down the principal. If you take an interest-only loan, though, you might face a large “balloon payment” of the outstanding principal at the end of the loan term.
Not every financial institution makes home equity loans, but large banks and credit unions tend to offer a menu of home equity loans and HELOCs. Unlike mortgages, which often are resold as investments and therefore tend to vary little from one lender to the next, home equity loans tend to stay in the lender’s portfolio. As a result, terms on home equity loans can vary widely by lender. The choices can become dizzying. For instance, Navy Federal Credit Union offers a selection of five-, 10-, 15- and 20-year home equity loans. For each term, the credit union has a variety of options, including loan-to-value ratios ranging from 70 percent to 100 percent and maximum loan amounts of $100,000, $250,000 and $500,000.
How Much Equity Could You Borrow?
Based on a 30-year loan term with a 4 percent fixed interest rate. The remaining loan balance after five years was calculated with MoneyGeek’s mortgage calculator.
|Current home value:||$210,000|
|Current loan balance:||$162,806|
Difference between current home value and current loan balance
Most lenders would only allow Sara to borrow up to 85 percent of her equity, or about $40,115.
Common Uses for a Home Equity Loan
This is a classic use of a home equity loan. Ideally, the pain of incurring new debt will be offset by the increase in your home’s value.
Using the proceeds of a home equity loan to retire credit card debt can lower your costs.
This use isn’t so straightforward. Be careful not to sacrifice your retirement stability to subsidize your kids’ tuition.
You could use the proceeds to start a business or buy an investment property. An obvious risk: If the investment goes south, how will you repay the loan?
If you have a car loan, private student loans or other high-interest debt, you might be able to save by using a home equity loan to pay off that debt.
What Are the Costs Involved?
It’ll cost you to tap into your equity, and interest on the loan is just one expense. Appraisals, credit checks and title work are all part of the tab. Many lenders cover the closing costs, however. NASA Federal Credit Union, for example, estimates closing costs on a $100,000 home equity loan range from $1,200 to $2,100, and says its borrowers must repay the closing costs if they close the home equity loan within three years.
|Type of Fee||What the Fee Includes||Cost Range|
|Application fee||This varies from lender to lender.||$0 to $50|
|Appraisal fee||In some cases, the lender will use an automated valuation model, or AVM, instead of an appraisal. The cost is $50 to $95. If your lender needs a “desk appraisal,” the cost might be $350 to $450. A full drive-by appraisal.||Up to $700|
|Notary signing services||You might not need the full legal attention that normally accompanies a mortgage.||$150|
|Title search and insurance||Lenders want to make certain you really hold title to the property you’re using as collateral.||$350 to $1,000|
|Credit report fee||Lenders will want to determine your creditworthiness as a borrower.||$10 to $25|
|Flood certificate||This determines whether the property requires flood insurance.||$10|
|Tax check||This lets the lender know if you’ve paid your property taxes.||$10|
How Home Equity Loan Rates Are Determined
Rates on home equity loans typically run a couple percentage points higher than rates for mortgages. Lenders typically base home equity rates on an index. The prime rate is a common benchmark, but lenders also can use the London Interbank Offered Rate or another index. The term of the loan and the amount of equity you have will affect your rate. A five-year loan will cost less than a 15-year loan. And the higher the loan-to-value ratio, the higher the interest rate, because the lender takes on a greater risk of a loss. Fixed-rate loans usually offer higher interest rates as a trade-off of having a stable, predictable payment, whereas variable rates change with the underlying interest rate.
Do You Qualify to Borrow a Home Equity Loan?
During the real estate bubble, practically anyone could borrow as much as they wanted against their home equity. Loan-to-value limits went as high as 125 percent. However, during the depths of the Great Recession, home equity loans were far harder to get. Now, home equity lending has returned to something of an equilibrium, and loans are widely available. However, to qualify, you’ll need excellent credit and plenty of equity. Because banks and credit unions keep home equity loans on their books, they’re on the hook for losses — and, naturally, they’re picky about who can borrow money.
Lenders typically require a FICO score of 720 to 740 to consider your application. You’ll also need plenty of equity in your home. Lenders generally limit loan amounts to 80 percent or 85 percent of the equity you have in your home, which is your home’s value minus your mortgage balance. So, if you have a $150,000 first mortgage on a home that’s worth $250,000, you potentially could borrow up to $85,000 through a home equity loan. Occasionally, home equity products limit loan amounts to 70 percent, and a few may go as high as 100 percent.
The Application Process
In many ways, applying for a home equity loan is like applying for a mortgage. A credit check, proof of income, an estimated value of your property, the amount you owe to your mortgage lender, recent pay stubs, latest tax return and bank statements will all be necessary. Depending on your lender’s policies, you also might need to pay for a title search and an appraisal. To obtain your credit score, the bank will ask for a Social Security number. If you have investment income or self-employment income that you’d like the lender to consider, you’ll need to document that as well as home-related expenses such as property taxes, homeowners association dues, insurance premiums and monthly mortgage payments.
Tips for a Successful Loan Application
There are two main reasons a lender rejects an application for a home equity loan: less-than-stellar credit and too little home equity. Johnna Camarillo, manager of equity lending at Navy Federal Credit Union, offers these tips for making sure your application sails through:
Use a third-party site to check your home’s value. Their estimates aren’t always spot-on, but they’ll give you an idea of how much your house is worth and, therefore, if you have enough equity for a loan.
Check your credit report. Scrutinize the report for mistakes and make sure your credit score is at least 720
Clean up the exterior of the house. Lenders typically take photographs from the street; ladders, dumpsters or other obvious signs of construction may affect the appraisal.
What If You Change Your Mind?
Uncle Sam lets you back out of a home equity loan within the first three days after closing, without penalty. The three-day cancellation rule applies only to home equity loans on primary residences. Essentially, there’s a three-day cooling-off period that starts when you sign the contract for a loan; the lender can’t deliver the funds for three days. If you’re using the proceeds for a home improvement project, your contractor can’t start work for three days. Federal law considers Saturdays as business days, but not Sundays or legal holidays.
How to Cancel a Home Equity Loan
If you decide to cancel within three days of closing, you must inform the lender in writing. Phone calls and face-to-face conversations don’t count. Your written notice must be mailed, filed electronically or physically delivered to the lender before midnight of the third business day. If you cancel the contract, the lien on your property goes away and you are not responsible for any amount, including the finance charge. The lender has 20 days to return any payments you made and to release any security interest in your home. If you received money or property from the creditor, you may keep it until the lender shows that your home is no longer being used as collateral and returns any money you’ve paid.
Home Equity: By the Numbers
It seems obvious, but taking a home equity loan requires equity, and not just a little. Thankfully, as the housing market recovers, most Americans have regained equity lost to the crash. At the end of 2015, 6.4 million U.S. homes were “seriously underwater,” according to RealtyTrac. That means the loan is at least 25 percent more than the home’s market value. On the other hand, fully 12.6 million American homes were “equity rich,” meaning the mortgage was less than half the house’s value. Where you live is a crucial variable.
Finding a Lender for Your Home Equity Loan
To get the best deal on a home equity loan, shop around. But that can prove easier said than done.
If you’re applying for a mortgage, you might be able to scout deals from multiple lenders online or by calling a mortgage broker who represents many lenders. It’s not as easy for home equity loans, which often have idiosyncratic rules. Contact two or three banks and credit unions to find out the rates and fees they charge. Big banks such as Chase and Wells Fargo offer home equity loans; so do large credit unions like Navy Federal and Pentagon Federal. It might make sense to borrow from a bank where you already have an account. Chase and TD Bank, for instance, offer discounts to borrowers who are existing customers.
How to Compare Lenders
Deals can vary widely from lender to lender. If a lender is focusing on home equity loans this month, it might offer sweet deals. If home equity loans aren’t a point of emphasis, rates and fees might be higher. That’s why it’s important to compare pricing from several lenders.
Begin with your own bank or credit union. Credit unions are nonprofits, so their rates and fees can be cheaper than those charged by banks. For more suggestions, visit reputable consumer review websites.
Candid lenders acknowledge they’re not always going to offer the best deal every time, so it makes sense to compare multiple deals.
You’ll need to submit information about your home, your mortgage and your income.
If you’re approved, the lender will provide a Loan Estimate that shows rates, costs and fees. Review each document for an apples-to-apples comparison.
Refinancing Your Home Equity Loan
Ideally, a home equity loan is a short-term financial tool that will tide you over for a few years, and it’s something you should strive to pay off. But you may become eligible for a lower rate than was offered on your original home equity loan. If your lender still owns your loan, it’s possible you’ll pay a small “modification fee” to switch the loan to a lower rate. You could also refinance into a new home equity loan or mortgage that will allow you to pay off your existing mortgage and home equity loan, yielding a lower combined payment. Keep in mind, refinancing isn’t free — you’ll have to pay for another appraisal, plus title work and other costs.
Common Misconceptions About Home Equity
Myth: Home equity loans are the best way to take out cash.
A home equity loan might seem a quick-and-easy way to tap into your property’s value. But Ed Conarchy of Cherry Creek Mortgage in Gurnee, IL, says refinancing your entire mortgage is the wiser play.
“Just redo your first mortgage,” Conarchy says. “You’ll get a little bit lower interest rate, and you’ll get the cash, too.”
Home equity loans typically are a point above the Wall Street Journal prime rate (which stood at 3.5 percent for much of 2016), so the 4.5 percent you’d pay on a home equity loan is about a point higher than the typical 30-year mortgage rate as of early August. What’s more, home equity rates are variable, meaning they can go up.
Myth: A home equity line of credit is a reliable rainy-day fund.
Home equity lines of credit can be yanked away at any moment. Unlike a mortgage, which is there as long as you keep making the payments, home equity loans shift power to the lender.
“A home equity line is basically a personal loan securitized against your house,” Conarchy says. “It has all these outs where the banker can freeze the loan or call the loan. We saw this happen all the time in 2008. We teach people: You can’t use a home equity line of credit as your rainy-day fund, because it might not be there when you need it.”
If you lose a job, or your home value falls, the lender can end the loan.
Myth: Home equity loans are a savvy alternative to paying mortgage insurance.
If you borrow more than 80 percent of your home’s value, you have to pay mortgage insurance. Borrowers used to get around this reality by taking out a second “piggyback” loan. But mortgage insurance premiums have plunged in recent years, undermining this tactic.
“Piggyback loans no longer make sense,” Conarchy says. “Mortgage insurance has never been cheaper than it is today.”
Myth: A home equity loan is as quick and easy as a car loan.
In fact, qualifying for a home equity loan is nearly as time-consuming as getting a mortgage. “Because they’re putting their houses on the line, we need to verify more,” Camarillo says. “And there’s a lot of regulation that goes along with that.”
Terms to Know
Automated valuation model: Popularized by Zillow.com, this tool offers an estimate of your home’s value without a full appraisal.
London Interbank Offered Rate (LIBOR): Sometimes used as a benchmark for interest rates on home equity loans. LIBOR is the rate international banks charge one another for Eurodollar and Eurocurrency loans.
Piggyback loan: Say you need to borrow more than 80 percent of your home’s value but you don’t want to pay mortgage insurance. A second loan lets you achieve this goal.
Prime rate: A common benchmark used by banks to set rates on home equity loans. It’s the interest rate banks charge their most creditworthy commercial customers.
Other mortgage-related terms are covered in MoneyGeek’s glossary.