How does a home equity loan work?

Why people use home equity loans

Most people take on a home equity installment loan when their debts get out of control. Home equity loan rates are generally lower than a high-interest credit card or what you'd pay on other personal loans.

Other people use a home equity loan to do renovations or improvements at home. While it's doable, a home equity loan probably isn't your best option in this case. We'll get into options a bit later.

Lastly, people use the equity in their homes for straight cash. And you can spend it on anything. Home equity loan lenders really don't care how you're spending the money. However, they want their money paid back on time, every time, with interest charged on top of the principal.

What is home equity? The details.

Plain and simple, home equity is the value of your home, minus what is still owing on your first mortgage. We'll show you an example, so it's clear.

Your home equity loan eligibility will depend on several things. While this type of fixed-rate loan allows you to tap into the worth of your home, it's essential to know the benefits and drawbacks.

Here's an in-depth example of how home equity is determined. In this example, our homeowners James and Shauna own a three-bedroom bungalow in the Midwest.

• Current appraised value of home: $350,000.
• Current balance on first mortgage: $200,000.

Did you note in the example that we said appraisal? We often get asked if a home appraisal is really necessary for a home equity installment loan. And the answer is always yes.

Home equity loan lenders always require an appraisal of any property to determine your home equity loan eligibility. In addition, it protects the lender if the borrower defaults. If a fixed-rate loan goes into default, the lender takes over the property to recoup its losses.

Okay. Using the example above, James and Shauna have $150,000 worth of equity in their home. So that means they can get a home equity loan for $150,000, right? No. That's not quite how a home equity loan works. Keep on reading. We're getting to that next!

How does a home equity loan work?

Home equity loan lenders only let you borrow between 80% and 85% of the actual value you've earned in your home. And remember, they also subtract what is still owing on your first mortgage. If you get approved for a home equity installment loan, you'll have immediate access to a lump sum of money.

However, you'll have to repay this fixed-rate loan entirely over a set number of years. You'll be paying principal and interest every month. Penalties can be severe if there's a default or if you want to make changes to your installment loan.

Home equity loan lenders always do the math to ensure they're covered if a borrower defaults on a loan. With a home equity loan, lenders always take two steps before they let you borrow anything:

• Step 1

  The value of your home is multiplied by the percentage of value that home equity loan lenders let you borrow. The result is the maximum amount of equity you can borrow against, at whatever home equity loan rates you're given.

• Step 2

  The remaining amount on your first mortgage is subtracted from the maximum amount of equity you can borrow. That (finally!) is the total amount you can borrow in a home equity fixed-rate loan.

Now you know what home equity loan lenders do for an installment loan based on home equity. Let's take James and Shauna's example to calculate what their home equity loan would be.

• Current appraised value of home: $350,000.
• Current balance on first mortgage: $200,000.
• Home equity loan lender allows 80% of appraised value to be borrowed: $297,500.
• Subtract balance on mortgage: $200,000.

And there you have it. So in this example, James and Shauna would be allowed to borrow up to $97,500, right? Not so fast. James and Shauna will still have to meet all of their home equity loan lender's other requirements. So let's break those down here.

What home equity loan lenders require

Every home equity loan lender has its own list of requirements. Before they even consider you for a loan, you'll have to meet every one of those requirements. Some lenders may require even more of you! But here's what you will typically find on a lender's "laundry list."

• You must have at least 15% to 20% equity available in your home.
• You must have a credit score of 620 or higher (if a credit score is lower, don't even think about a fixed-rate loan).
• You must have a 43% (or lower) debt-to-income ratio (which is calculated by dividing all monthly debts by gross income before tax).

And that's just one part of the list of requirements by most home equity loan lenders. You will also need to provide this documentation:

• Real estate purchase agreement on your house including address, date of sale, purchase price, and property type.
• Social security number.
• Marriage certificate if applicable.
• Letter of employment.
• Past two years of W-2 forms from employer.
• Proof of income with paystub showing monthly and year-to-date earnings.
• Paperwork on other outstanding debts, including mortgage, credit cards, and auto loans.
• IRS Form 4506-T signed and completed.
• If self-employed, last two years of complete tax returns.
• Past two years of K-1 forms from a partnership, LLC, or S Corporation if applicable.
• Proof of insurance on home, hazards, and floods.

Great! You've made it through Home Equity 101. Instead of a final exam, this is our "pros vs. cons" cheat sheet to go over everything you've learned about home equity loans.

Pros vs. cons of home equity loans

Let's start with the good stuff. Here's what you may be able to count on if you find approval for a home equity loan on your current property.

Pros

• Budgeting might be easier on a fixed-rate loan with the same amount paid on principal and interest each month.
• Home equity loan rates are generally lower than personal loan rates or high-interest credit card rates.
• If you're lucky enough to have a current low mortgage, you do not have to refinance that.
• If your home equity loan is used for renovations or home improvement, interest may be deductible.

Right. On to the not-so-good stuff about a home equity loan. And keep reading because we're getting into some other options to a home equity installment loan next. Ultimately, the choice is up to you!

Cons

• Home equity loan lenders make you pay interest monthly on the entire installment loan.
• Interest payments on incremental spending (like for home renovations or remodeling work) makes bad financial sense.
• Home equity loan lenders can seize the property if loan payments are late or go into default.
• If you want to sell your home before you finish paying a home equity loan, you must repay the entire balance before the lender releases you.
• Home equity fixed-rate loans are totally inflexible, and a home equity line of credit might be better.

Did you catch that? We mentioned options other than home equity loans. A home equity line of credit is one of those options. Sometimes this type of loan option works better for people. Let's talk about it more.

What is a home equity line of credit?

When you talk to home equity loan lenders about a home equity line of credit, they'll probably call it a "HELOC." That stands for "home equity line of credit".

The requirements for a HELOC are pretty similar to those of a home equity loan, although some lenders have higher standards in approving a HELOC.

For instance, most home equity loan lenders require a credit score of at least 700 when a borrower is applying for a HELOC. If you get approved for a HELOC, the lender gives you a set amount in a line of credit. Then, you borrow against your credit line when you need the funds.

Most people who use HELOCs are doing renovations or property improvements. This type of loan arrangement can be helpful if you're not sure what your final costs will be. An example of this is the higher cost of building materials like wood, which got over 200% more expensive in recent years.

It doesn't matter how many withdrawals you make from your HELOC during what is called the "draw period". You can withdraw many times or leave the funds available for when you really need them.

Payments on a HELOC are pretty flexible, too. Depending on the term length of your loan, you can repay less for a few years. But when the payment schedule on your HELOC becomes fully amortized, you are all in for set payments on time and with interest.

What are the pros and cons of a HELOC?

A HELOC is definitely more flexible for borrowers who can manage this line of credit responsibly and with all of the risks involved. Here are the pros of a HELOC:

• During the "draw period", you only pay interest on the amounts you withdraw.
• Unlike fixed-rate home equity loans, HELOC interest rates are usually variable (based on prime rate + fixed margin).
• Payments during the draw period fluctuate with the interest rate, so they may be smaller if rates are lower.
• The draw period generally lasts 20 years.

Some downsides of a HELOC are the same as the problems with a home equity loan. That means that borrowing in any way from home equity loan lenders shouldn't be taken lightly. Here are the cons with a HELOC:

• A HELOC is a debt.
• A HELOC depletes the equity you've earned in your home.
• You could lose your home if your HELOC goes into default.
• A HELOC works like a credit card, so if a borrower tends to overspend on credit, this may be an issue.
• When interest rates rise, a HELOC debt gets more expensive.
• If you only make minimum payments during the draw period, you'll face very high payments when the loan becomes amortized.

And there's a hidden downside to HELOCs that more home equity loan lenders won't reveal. The lender is free to cancel your line of credit at any time. So it doesn't matter if you still need your line of credit, and that's always a risk for borrowers.

So we've compared home equity loans with a HELOC. You do have other options if neither of those types of loans seems to be a good fit.

Mortgage refinancing

Some people choose to refinance their mortgages at lower rates, with the impression that they can withdraw home equity in cash when the refinanced mortgage closes. It's s called a cash-out refinancing.

The issue with mortgage refinancing is, the new installment loan will change because the cash you withdraw is added to the new loan. Here's an example of cash-out refinancing:

• Current home appraisal value: $200,000.
• Amount owed on mortgage: $100,000.
• Mortgage refinancing: $130,000.
• Cash out from first mortgage: $30,000.

The cash received from mortgage refinancing can be beneficial, and this installment loan is bundled into one monthly payment.

Beware, though, because the approval process for cash-out refinancing can be frustrating. The following are things you should consider before you look for cash-out refinancing.

• Check your loan terms

  If you get your mortgage refinanced, the cash-out financing terms may take longer for you to pay off. In addition, your monthly installment loan may increase. Always ask a home equity loan lender for their closing disclosure terms before you proceed.

• Some home equity must stay put

  When you looked at the example of cash-out refinancing above, it appears that $30,000 could be immediately withdrawn on closing. But, unfortunately, that's not always the case.

  If you get approved for a conventional loan from any home equity loan lenders, they will require that you leave at least 20% equity in your home after a mortgage refinancing. An FHA installment is the same. It also has a 20% or more "equity in" requirement.

  An exception to the 20% home equity requirement is made for VA (Veterans Affairs) loans. Installment loans for our veterans generally aren't subject to any home equity requirements.

• It costs to close

  People sometimes forget that home equity loan lenders consider a mortgage closeout in the same way as when you bought your home. What does that mean? Unfortunately, it means you'll be facing closing costs by refinancing your mortgage. In addition, it includes the home appraisal fee that home equity loan lenders always require.

  Closing costs may vary across the country. But check out the requirements you'll need to pay when you do a cash-out refinancing in many states:

  • Attorney fees.
  • Home appraisal fees.
  • Credit report fees.

  When you add up the closing costs, any cash you're withdrawing starts to dwindle significantly. Oh yes, and there's another thing.

• Your cash will be delayed

  Because of the requirements for a home appraisal, recalculating the installment loan amount, and the legal process, you won't receive any money from your cash-out refinancing immediately.

  Home equity loan lenders must also abide by the Truth in Lending Act. It's to protect your interests in case you change your mind about the loan.

  But the issue is, you're given three days to make sure you want to proceed. And your cash is left waiting for up to five days after the new installment loan closes. So if you need cash immediately, think again. A cash-out refinancing option may not be as convenient as people assume it is.

More options available to cash-strapped homeowners

I'm pleased to tell you that homeowners always have choices. So when you've done your homework, you'll have the peace of mind to make the best decision for you. Here are alternatives to taking a loan out on your home's equity.

• Personal loans

  Yes, this is another loan. The difference is that personal loans are mainly unsecured. And that's good news and bad news. If you do get approved for a personal loan, the fact it's unsecured is good in one way. You won't need to put your home up as collateral (the bank can't seize it if something goes wrong with the loan).

  The bad news with an unsecured loan is, the interest rates are super-high. Of course, if a person's credit score is on the good side, the rate can decrease slightly. But in most situations, that's not a possibility.

• Better budgeting

  Sometimes it's best to declutter, downsize, and shift priorities. If you can cut your expenses or maybe even sell belongings you don't use anymore, it can add a bit to your bottom line. Unfortunately, it's often not enough to make a huge dent in a debt situation, but every little bit helps.

• Dip into investments

  If you have any money saved or investments growing, you may need to dip into them to get yourself out of a hole. Obviously, this isn't the wisest suggestion.

  Financial penalties are pretty severe when you need to get at an investment early. So weigh the pros and cons heavily here.

What is the last resort?

If all other loan arrangements or financing methods are exhausted, a homeowner may face a deed-in-lieu of foreclosure. It's a complicated-sounding term, but we'll explain it below.

With a deed-in-lieu of foreclosure, a homeowner walks away from their debts—and their home. They hand over the deed to their home equity loan lenders, and their debt is at least partially forgiven.

With this type of foreclosure, you no longer have any financial obligations with your property. So you're not being evicted, and the process generally isn't as hard on people emotionally.

But, even though you're losing your house, some home equity loan lenders might try to make you sell your home before you vacate it. It's like making you do the hard work without getting any financial benefit from the home selling process.

You have another choice

When you feel forced to sell your home, it's not a satisfying feeling. And when you know that you won't get any equity out of your home because your lender is telling you to sell, that's even worse.

Other options are available to you than the inconvenience, uncertainty, and expense of selling a home the traditional way. When you're aware of these alternatives, it will give you more confidence.

The old-school real estate market doesn't give you what you need in this situation. But check this out. The old-school real estate market has changed, in many ways, for the better.

There's a new type of home buyer today who will help you sell your home faster, with less stress, and entirely under your terms.

Our passion is helping homeowners make the best decision

When we hear people ask, what is home equity? We know that the follow-up question generally is, how does a home equity loan work? While we've answered those questions for you, we believe there's another way. You don't have to settle for a high-interest loan on top of another loan.

We hope this guide has empowered you. We want to empower you with even more information about how you can sell your home fast and gain cash from it.

Our way doesn't involve juggling debts and more uncertainty in the future. Instead, we can guide you through the process of this great new real estate market.

We have the connections and insights to sell your home quickly. We're here to guide you every step of the way. Submit your address today to get a no obligation cash offer!