Fixed or flexible?

How to get a home equity loan? That's a good question. You'll need to pick the right product, choose the best deal and apply for your loan.

Step 1: Pick the Right Loan

Home equity financing comes in two forms: a loan, which delivers a lump sum and (usually) comes with a fixed interest rate, and a home equity line of credit, or HELOC, that can be drawn on as needed during its term, and (usually) comes with a variable interest rate.

Home equity loans are very similar to a first mortgage, with a comparable set of costs and disclosures. You'll receive a lump sum, and you'll make fixed monthly payments until the loan is repaid.

HELOCs are revolving accounts, much like credit cards. Their terms are divided into two periods – the draw period, in which you can withdraw money up to your credit limit and make a minimum monthly payment, and the repayment period, in which you're no longer allowed to draw money, and your payment is calculated to zero out your balance over the remaining term of the loan. Some HELOCs are "convertible," which means the rate can be fixed once you've entered the repayment period.

Which is better? That depends on your reason for taking out the loan.

If you plan to spend the home equity proceeds all at once, for example for debt consolidation or a single large purchase, the home equity loan is probably your best bet. Its fixed interest rate and unchanging payment make budgeting easier, and it may be cheaper in the long run. If you need the money for ongoing or unknown expenses, like yearly college tuition or in case of an emergency, the HELOC's flexibility can make it the better choice.

All forms of home equity financing are mortgages, which means lenders can foreclose and take your property if you don't make your payments as agreed.

Step 2: Choose the Best Deal

Like first mortgages, home equity loans come with a wide variety of interest rates and terms. Be sure to obtain several written quotes from competing lenders so you know that your offers are fair. Home equity loans come with many of the same closing costs as purchase mortgages, so it really pays to compare mortgage quotes from several lenders. Home equity loan costs may include fees for:

  • Property appraisal
  • Origination
  • Escrow services
  • Title insurance

Some lenders may skip the appraisal in favor of some sort of automated valuation model -- a computerized estimate of your home's value based on its purchase price and recent property sales in your area. As with "first" mortgages, home equity loans can come with a variety of pricing structures, including "no cost" options -- loans in which the lender pays the closing costs in exchange for the borrower accepting a higher interest rate -- and loans with "bought down" or "discounted" interest rates, in which the borrower pays extra upfront to get a lower rate and payment.

HELOCs usually come with very low setup costs. There may be an annual service charge or membership fee. Many lenders offer lines of credit at no charge, although an early termination fee may apply. You may also be charged an inactivity fee if the HELOC is set up but not used.

Step 3: Apply for Your Loan

Once you've chosen your loan and your lender, it's time to apply for your home equity loan. The amount you'll be allowed to borrow depends on the amount of home equity you have -- most lenders will allow you to borrow against 80 percent of your home's value, while some will go to 90 percent. Calculating your maximum loan amount is simple:

  • Multiply your home's value by .8 (for an 80 percent loan). If your property is worth $100,000, your result is $80,000.
  • Subtract the amount of your first mortgage. If you owe $60,000, your result is $20,000.

This means you can borrow up to $20,000 with a home equity loan or line of credit.

In addition to home equity, you'll need a decent credit rating (a 660 to 680 minimum credit score for most loans). You must prove that you have enough income to make your loan payments. Your debt-to-income ratio (DTI) should not exceed 43 percent. Here's how you calculate your DTI:

  • Add your total house payment (including taxes and insurance) to your other monthly obligations like auto loans, student loans and credit card payments (but not living expenses like food or utilities), plus the estimated payment for the new second mortgage.
  • Divide that total by your monthly gross (before tax) income. That's your debt-to-income ratio. If your house payment is $1,000 per month, your auto payment is $300, your credit card minimum payments come to $200 and your new home equity loan payment would be $250 (that's $1,750 altogether), and your gross income is $5,000 per month, your DTI is $1,750 / $5,000, or .35 (35 percent).

How to get a home equity loan? It's not hard. Home equity loan applications can usually be processed much more quickly than first mortgage applications -- many lenders take about two weeks to approve your loan and get you your money.