May 19, 2024

Housing Finance Development

It's Your Housing Finance Development

Is Taking Out a Home Equity Loan Right for You?

If you have more than 20% home equity and a credit score of at least 680, there’s a good chance you could qualify for a home equity loan. This allows you to borrow money for about five to 10 years at a relatively low fixed interest rate using your home as collateral. Let’s talk about how home equity loans work, so you can decide whether one might make sense for you.

Key Takeaways

  • A home equity loan lets you borrow against the equity you have built up in your home, providing a single lump-sum payment that can be useful for financing big-ticket items or consolidating higher-interest debt.
  • However, because you are using your home as collateral for the loan, it puts you at risk of losing it if you default on the loan.
  • Home equity loans come with low fixed interest rates and repayment periods of anywhere from five to 10 years.
  • Alternatives to home equity loans include home equity lines of credit (HELOCs), personal loans, and low-interest credit cards.

Understanding Home Equity Loans

A home equity loan, which is a kind of second mortgage, lets you borrow against your home’s value. It works similarly to a first mortgage, but the interest rates are slightly higher. You borrow a lump sum all at once and make identical monthly payments of principal and interest for the next five to 10 years, depending on the loan term you choose. Your home is collateral for the loan, so if you don’t repay what you borrow, you could lose your home in foreclosure.

How Much Equity Do You Have?

The first step in deciding if a home equity loan is right for you is knowing how much home equity you have. This will give you an idea of whether you’re eligible and how much you might be able to borrow.

Your home equity is the difference between your home’s appraised value and your mortgage balance. If your home is worth $450,000 and you owe $225,000, your equity is 50%. If you’ve paid off your mortgage completely, your equity is 100%.

To see how much you might be able to borrow with a home equity loan, you need to calculate a combined loan to value ratio (CLTV) ratio. Most home equity lenders allow a CLTV ratio of at least 80% on your main home, though Regions Bank goes to 85%, Discover to 90%, and Spring EQ reaches 97.5%.

Again let’s say your home is worth $450,000 and you owe $225,000 on your first mortgage. Multiply $450,000 by 0.8 to get how much debt most lenders will be comfortable letting you carry against your home: $450,000 x 0.8 = $360,000. Then subtract $225,000 from that: $360,000 – $225,000 = $135,000. This is how much you can borrow.

What Else Do You Need to Qualify?

The minimum credit score to get a home equity loan depends on the lender, but it is typically at least 680. Keep in mind that merely qualifying will not get you the best available rate, and you might not get approved for as high a CTLV ratio as someone with excellent credit would.

You’ll need to provide pay stubs, income tax returns, and bank statements to lenders to document your income. You’ll need to show that you have enough stable income to afford the additional monthly payment and not too much debt.

Per the Fair Housing Act, mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on “race, color, religion, sex (including gender, gender identity, sexual orientation, and sexual harassment), familial status, national origin, or disability,” there are steps you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CPFB) or the U.S. Department of Housing and Urban Development (HUD).

Many home equity lenders like to see a debt-to-income (DTI) ratio no higher than 43%, meaning that your monthly mortgage, student loan, auto loan, credit card, and proposed home equity loan payments should not be more than 43% of your pretax income.

Do You Want to Use Your Home as Collateral?

A home equity loan, like other home loans, is secured by your home. If you don’t repay it, you could end up in foreclosure. Yes, you’re already in this situation if you’re carrying a first mortgage. However, additional borrowing against your home increases the risk that you’ll fall behind on payments if your finances change for the worse.

If you don’t want to use your home as collateral, you might consider an unsecured personal loan.

The consequences of defaulting on any loan are serious and include difficulty obtaining future credit and potentially being sued by your creditors, who may even obtain a judgment lien on your home. However, you’re less likely to lose your principal residence when you’re not using it to secure your loan.

Do You Want the Lowest Possible Monthly Payment?

You start repaying a home equity loan’s principal and interest from your first monthly payment. However, with a home equity line of credit (HELOC), many lenders offer the option to pay only the interest on what you’ve borrowed for the first 10 years. In addition, the starting interest rate is usually lower than a home equity loan’s starting rate. In exchange for these initial rewards, you have to take on more risk. HELOCs have a variable interest rate that’s tied to the prime rate.

In turn, the prime rate is influenced by the federal funds rate. If the Federal Open Market Committee (FOMC), in any of its eight yearly meetings, decides that inflation is too high, it will take steps to increase the federal funds rate, and your HELOC’s rate is likely to follow.

Further, when you don’t pay principal for the first 10 years of your HELOC, you’re betting that you’ll have an easier time repaying that money in the future than you would today. If your bet turns out to be wrong, you could find yourself with some seriously unmanageable debt, especially if interest rates are substantially higher.

Do I Have to Get a Home Equity Loan From the Same Company That Services My Existing Mortgage?

No. While your loan servicer might send you offers advertising its home equity loan rates, you can get a home equity loan from any lender that will approve your application. You should definitely shop around with multiple lenders to make sure you get the lowest rate and fees possible.

Can I Deduct the Interest on a Home Equity Loan?

You may be able to deduct the interest you pay on a home equity loan if you use the money “to buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the Internal Revenue Service (IRS). As the Tax Cuts and Jobs Act (TCJA) of 2017 nearly doubled the standard deduction and lowered the amount of combined mortgage debt on which you can deduct interest to $750,000, many people won’t save much, if anything, from the mortgage interest tax deduction. You’ll need to do the math to see if the possible tax deduction could make this loan an attractive choice for you.

The TCJA is set to sunset in 2026. If Congress allows it to expire, which would reinstate the previous laws, homeowners will be able to deduct mortgage interest regardless of how they spend the money, the standard deduction will become less appealing, and interest on mortgage debt up to $1 million will be tax deductible. In short, it’s hard to say whether you’ll be able to deduct your home equity loan interest now, let alone in 2026 and after.

Should I Pay Off My High-Interest Debt With a Home Equity Loan?

Maybe. Home equity loan rates are much lower than credit card rates, so your monthly savings could be substantial. Home equity loans also have a fixed term, unlike credit cards, meaning that, at least in theory, you’ll eventually be debt free. We say “in theory” because you might be able to continually refinance your home equity loan, although that possibility hinges on a lot of variables, including home value, interest rates, income, overall debt, and credit score.

A home equity loan might also give you access to even more borrowing power than you had with your credit cards. If you’re not careful, your debt situation could get more untenable.

Finally, taking up to 10 years to repay your credit card debt with a home equity loan could mean that you’ll pay much more interest in the long run. On the other hand, you’ll get a fixed interest rate, and inflation will make those fixed monthly payments less and less painful over time. Inflation benefits debtors.

The Bottom Line

Taking out a home equity loan may be right for you if you want to borrow a lump sum at a fixed interest rate, repay the loan with stable monthly payments over anywhere from five to 10 years, and are comfortable taking on additional debt secured by your home.

If you want to borrow smaller sums as you need them, a HELOC might be a better choice. If you don’t want more debt secured by your home, a low-interest credit card might be the way to go. However, you will have to be able to manage the monthly payment swings caused by variable interest rates.

An unsecured personal loan is another way to borrow at a fixed interest rate. The interest rate may be higher and the term may be shorter than you could get with a home equity loan, and you may not be able to borrow as much. However, this type of loan will not directly put you at risk of losing your home.

Finally, if you’re considering borrowing money for something that would be nice to have but isn’t a necessity, consider leaving your equity alone and not taking on additional debt. Many people enjoy the sense of security that comes from owning their home outright.