Guide to Home Equity Loans
A home equity loan is similar to a personal loan, but you’re putting your house up as collateral.
The bank lends you a lump sum of money at a fixed interest rate, and you agree to repay it over a set period of time, which may be as long as 25 years.
The APR for a home equity loan may be higher than what you’d pay for a first mortgage, but it’s typically a cheaper borrowing option than a credit card.
- 1. What is a Home Equity Loan?
- 2. Home Equity Loan Benefits
- 3. Home Equity Loan vs. HELOC: What’s the Difference?
- 4. Home Equity Loan Fees
- 5. Find the Best Home Equity Loan
1. What is a Home Equity Loan?
Home equity loan defined
Home equity loans are available only to homeowners who’ve built up equity value in the property.
Equity simply means the difference between the amount that’s left on your mortgage and the home’s appraised value.
For example, if you owe $200,000 on a home that’s worth $230,000, you’d have $30,000 in equity that you could borrow against.
Lenders typically allow you to borrow up to 80 percent of the equity you’ve built up.
Since your home serves as the collateral for the loan, the bank has the option of foreclosing if you default on the payments.
Qualifying for a home equity loan
While having equity in your home is the number one requirement when applying for a home equity loan, that’s not the only thing lenders are looking at.
Just like when you bought the home, you’ll have to go through the process of verifying your income and your work history.
The bank will also check your credit report and score to see how much debt you owe and how consistent you are about paying your bills.
Your score is one of the most important factors because it determines what kind of interest rate you’ll pay on the loan.
Here are pros and cons and five scenarios to help you better understand home equity loans.
2. Home Equity Loan Benefits
Why choose a home equity loan
A home equity loan is a good fit for homeowners who need to borrow a large sum of money for a one-time financial need, such as financing a major home improvement project or consolidating debt.
Unlike a credit card, which only requires you to make a minimum payment each month and doesn’t impose a time frame on the payoff, a home equity loan comes with set terms so the debt isn’t allowed to linger indefinitely.
Advantages of a fixed-rate
Another benefit of choosing a home equity loan over other types of loans or lines of credit is the fixed interest rate.
With a variable rate, the amount of interest you pay over the life of the loan is never set in stone since the rate can change.
A fixed rate means your monthly payments are consistent and you always know exactly what you’re paying in interest.
As an added plus, the interest you’re paying on the loan is tax-deductible up to the first $1 million.
3. Home Equity Loan vs. HELOC: What’s the Difference?
How a home equity line of credit works
Home equity lines of credit are sometimes lumped together with home equity loans as being the same thing but there are some key differences between the two.
With a home equity line of credit or HELOC, you don’t get the money all at once.
Instead, the bank sets up a revolving line of credit for you based on your home’s equity value. You can access this line of credit whenever you need to.
Home equity lines also come with a variable interest rate, which means your payment could go up or down each month.
When you’re better off choosing a HELOC instead
Compared to a home equity loan, HELOCs tend to come with slightly lower interest rates, which can work to your advantage if you’re not planning to max out your credit line all at once.
If you have annual recurring expenses that take a big bite out of your budget, such as your child’s tuition costs or property taxes, tapping your HELOC is a less expensive option than charging it to a credit card.
A home equity line of credit also offers more flexibility in terms of repayment, since lenders may allow you to just pay the interest only for the first 5 or 10 years of the loan term.
4. Home Equity Loan Fees
Home equity loan closing costs
A home equity loan is essentially a second mortgage, which means you’ll be paying the same kind of fees you would if you were actually buying a home.
Some of the most common fees involved include the loan application fee, origination fees, attorney fees, title search fees and appraisal fees.
Some banks may waive some or all of these fees for existing customers.
If you do have to pay closing costs, they can run anywhere from 2 to 5 percent of the loan value, so that’s something you need to factor into your budget before you apply.
Be aware of penalties
Home equity loans are good for lenders because they’re able to cash in on the interest you’re paying over the long term, but your wallet ends up paying the price.
Knocking a home equity loan out early can save you some money but your lender may punish you for it in the form of a prepayment penalty.
If there’s a possibility that you’d be able to pay off your home equity loan ahead of schedule, you need to check your loan documents carefully to make sure you it’s not going to cost you anything extra.
5. Find the Best Home Equity Loan
Shop around for the best rates
Home equity loan rates can vary widely from one lender to the next and you’re doing yourself a major disservice if you’re not shopping around to see what’s out there.
Even if it’s just a difference of a half a percentage point, that can translate to hundreds of dollars in interest you won’t have to pay to the bank.
If you’re not sure where to begin, compare rates for home equity loans from thousands of banks and credit unions nationwide.
Review the loan terms
When you’re weighing your home equity loan options, one thing you don’t want to do is zero in only on the interest rate.
You also need to consider the different fees each loan option involves, the length of the repayment term that’s being offered and whether any discounts are available.
For example, you may be able to get a 0.25 percent reduction in your interest rate if you open a checking account with the lender and set up automatic payments for the loan.
Know your cancellation rights
If you’re approved for a home equity loan, you have a limited window of time to change your mind.
Under federal law, you have three business days to cancel a credit agreement and you have to let the lender know in writing what your plans are.
Otherwise, you’re officially on the hook for repaying the loan and you can’t recover any fees or other costs you paid during the approval process.
Simon Zhen is a research analyst for MyBankTracker. He is an expert on consumer banking products, bank innovations, and financial technology.
Simon has contributed and/or been quoted in major publications and outlets including Consumer Reports, American Banker, Yahoo Finance, U.S. News – World Report, The Huffington Post, Business Insider, Lifehacker, and AOL.com.