What Is a Home Equity Loan?
A home equity loan is just what its name suggests: a loan secured by the equity in your home. Your equity is the difference between your mortgage balance and the market value of the home.
For example, if you have a mortgage with $150,000 left to pay and your home was recently appraised at $200,000, your equity is $50,000. Depending on the lender, you could borrow up to 80% to 90% of that amount using your equity as collateral.
Even if you think you know the market value of your home, however, the lender may require that a certified appraiser perform a separate valuation. At that point, you’ll know how much you can borrow.
Just because you have equity, though, doesn’t mean you can secure a loan. Your credit score and other factors will also come into play.
How Your Debt-to-Income Ratio Plays a Role
Your debt-to-income ratio (DTI) is a measure of how much of your monthly income goes to service debt. To calculate your DTI, divide your monthly debt payments by your gross income.
For example, let’s say you have a gross monthly income of $5,000 and the following monthly payments:
- $1,000 mortgage payment
- $100 credit card payment
- $250 car loan payment
- $300 student loan payment
That’s a total of $1,650 in debt, giving you a DTI of 33%. To give you an idea of how that stacks up, many mortgage lenders prefer a ratio below 36% when originating a first mortgage loan. Other lenders might be fine with a DTI of 50% or below.
That said, DTI requirements for a home equity loan can vary by lender. If you find that your DTI may be considered high, it’s better to be safe than sorry. You can avoid a potential denial by paying down existing debt before applying for a home equity loan. You’ll also be better off financially with less debt eating up your income.
Is a Home Equity Loan Right for You?
Home equity loans can be a good borrowing option in the right circumstance, but there are some things to consider. Here’s a quick summary of the pros and cons.
Pros of a Home Equity Loan
Low interest rates: While a lower credit score could give you a higher interest rate, you’ll likely still get a lower rate than you would with a personal loan. That’s because the collateral—your home’s equity—lowers the risk to the lender.
Interest may be tax-deductible: If you use your loan to buy, build or substantially improve the home you use to secure the loan, you may be able to deduct the interest you pay. The deduction is available for qualified mortgage loans up to $750,000.
No restrictions for how you use the money: Home equity loans function similarly to personal loans in that they don’t require that you use the loan for a specific purpose. This means you can use a home equity loan to consolidate other debt, pay for home improvements or cover the cost of tuition for one of your children.
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Cons of a Home Equity Loan
You could lose your house: Because your loan is secured by your home’s equity, the lender has a right to that equity if you default on the loan. To get its collateral, the bank could foreclose on you and take the house to satisfy the debt.
High costs: Just like your mortgage loan, home equity loans typically come with closing costs and fees. Depending on the lender, these costs could neutralize the savings you’d get with a lower interest rate.
You could end up underwater: If you tap a large portion of your home’s equity, it could leave you owing more than the house is worth if property values drop in your area.
The Bottom Line
Before you borrow with a home equity loan, it’s important to know what you’re getting yourself into. It’s also essential to understand what your chances are of getting approved. If your credit score, DTI or credit report need some work, put off borrowing until they’re in better shape.