The Costs, Perks and Risks of Borrowing Against Your House
Guide to Home Equity Loans: Pros & Cons, Requirements & Limit
Quality Verified
Updated: March 31, 2024
Quality Verified
Updated: March 31, 2024
Advertising & Editorial Disclosure
Getting a home equity loan can be considered as taking another mortgage against your home. The lender, usually a bank, provides the borrower with a lump sum that is equivalent to your home’s equity.
If the borrower fails to pay their home equity loan, the lender can foreclose the house. Private lenders usually allow borrowers to loan around 80% to 85% of their home’s value. Home equity loans have a fixed repayment plan, interest rates and monthly payments.
Borrowers decide how they use the money received from their home equity loan. However, it has its drawbacks. Home equity loans are a potential debt trap and it also reduces the house’s equity. Thus, it’s essential to understand how home equity loans work so you can decide if it’s the best option for your financial needs.
How Does a Home Equity Loan Work?
A home equity loan is one way you can meet your financial goals since you turn your house’s equity into cash. You can apply for a home equity loan at a bank, with an online lender or with a credit union.
Equity refers to the difference between the value of the house and how much you still owe your lender for your mortgage. There are different ways that equity can grow. For example, it increases when an area’s real estate value goes up and when the borrower consistently pays their mortgage.
The amount you can borrow varies based on your home’s equity and several financial factors. When you’re qualified to take out a home equity loan, the lender will disclose the loan amount, interest rate, related fees, monthly payments and loan term. Once you agree to the loan terms, the lender will release the funds as a lump sum.
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.
Common Uses for a Home Equity Loan
It’s up to you to decide how to use the money you receive from a home equity loan. But MoneyGeek strongly advises you to only use the money for important matters. Examples can be found in the table below.
Calculating Your Equity
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.
- Step 1: Get an estimate of your home’s value
- Step 2: Find out the percentage you’re allowed to borrow from the lender
- Step 3: Multiply your home value with the percentage to get the maximum equity amount you can borrow
- Step 4: Determine your remaining loan balance
- Step 5: Deduct your remaining loan balance from the maximum equity amount you can borrow
- Step 6: The answer will show you the total amount you can borrow
Pros and Cons of a Home Equity Loan
Home equity loans are ideal for borrowers who plan what they’ll use the money for and know exactly how much they need to maximize it. It’s best to use home equity loans for significant expenses like funding education or home renovation.
Generally, home equity loans have many advantages. However, it’s not recommended for everyone, especially individuals who don’t want to risk their house which is used as collateral by the lender.
Another risk you may run into is overborrowing, which can leave you drowning in debt. Therefore, it’s wise to assess the pros and cons of a home equity loan to help you determine if it’s worth your while.
Interest Rates and Fees for Home Equity Loans
More often than not, the cost of your home equity loan is more expensive than your primary mortgage. However, home equity loan rates are more competitive compared to personal loans and cash-out refinances.
Factors like prime rate, credit score, credit limits and loan-to-value (LTV) ratios influence your home equity loan rate. While the prime rate is typically used as the benchmark for lenders, it’s possible to use another index such as the London Interbank Offered Rate. Loan terms also affect rates because the longer the loan term, the higher the rate. Meanwhile, a high loan-to-value ratio means that your rates increase because the lender is at a greater risk of loss.
Aside from the home equity loan interest, you’ll need to shoulder costs for appraisals, credit checks and title work. When it comes to closing costs, some lenders cover it while others won’t. Certain lenders require borrowers to repay closing costs if they don’t meet specific conditions.
Applying for a Home Equity Loan
Home equity loans are available to most individuals. In order to take out a home equity loan, you usually need excellent credit and a great amount of equity. To consider your application, lenders typically require a FICO score of 720 to 740. Some lenders are willing to consider borrowers with a credit score of 620 or higher if they have a verifiable income history for two or more years.
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.
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.
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.
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.
Finding the Right Lender
Fees and other important costs vary per lender. So, before you commit to a loan, be sure to shop around and review deals per lender. It’s best to choose a deal that offers you the most favorable terms for your situation.
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.
Start by finding lenders in your area.
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.
Narrow your list of lenders to at least three.
Candid lenders acknowledge they're not always going to offer the best deal every time, so it makes sense to compare multiple deals.
Apply for home equity loans.
You'll need to submit information about your home, your mortgage and your income.
Compare all Loan Estimates you've received.
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.
Home Equity Loans vs. HELOCs
Another way to turn your home equity into cash is to get a Home Equity Line Of Credit, or HELOC. It functions like a credit card where the cardholder has a revolving line of credit. Borrowers are given a set amount of money and can withdraw from it when needed.
For HELOCs, a borrower can make draws within the draw period that the lender sets, which is usually between 5 to 10 years. After this time frame, a repayment period occurs. Borrowers aren’t allowed to withdraw money anymore.
HELOCs have variable interest rates, thus rates will change depending on the current conditions of the market.
Common Misconceptions About Home Equity
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, Illinois, 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.
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.
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."
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."
About Jeff Ostrowski
