Homeowners who want to borrow against their equity for home improvements or other needs have three options: a new first mortgage with a cash-out component, a home equity loan or a home equity line of credit, often called a HELOC.
Home equity loans and HELOCs are usually second loans, taken out by homeowners who already have a first mortgage, says Casey Fleming, a mortgage adviser and author of The Loan Guide: How To Get the Best Possible Mortgage, an independently published book.
Home equity loans typically have a fixed rate and specified repayment term. HELOCs are open-ended revolving credit lines, similar to a credit card, only secured by the borrower's home.
"It would be very unusual for someone to get a home equity loan if they weren't putting it in second position because then they would just get what we would call a 'regular,' or first, mortgage," Fleming explains.
A HELOC might be a homeowner's second home loan or, if the first mortgage has been paid off, only home loan.
Home equity loans typically have a higher interest rate than first mortgages. HELOCs often have a variable rate.
Home Equity Loan or HELOC?
So, which option is best?
A home equity loan is a good choice for homeowners who "have no tolerance for a variable rate and need to know how much their payment is going to be," Casey says. That's because the home equity loan's fixed rate and set repayment term mean the monthly payment will never change as long as the borrower has the loan.
Another feature of the home equity loan is that the homeowner gets all the money up front rather than on a borrow-as-you-go basis.
"You get your money all at once," Casey says. "So it would be best for somebody who knows exactly how much they need, and they're going to borrow it on a one-time basis."
Home equity loans are most often used for major home improvements like installing solar panels or a swimming pool, remodeling a kitchen, putting on a new roof or adding on an addition. Other uses include debt consolidation and purchases of big-ticket items, like a car or boat.
A home equity loan can also be a good alternative to contractor's financing, which might be more expensive for the homeowner.
Who Is the Perfect Candidate?
The ideal borrower for a home equity loan has plenty of equity.
"Most home equity loans will go to about 80 percent combined loan-to-value, so the first and second (loan balances) combined can be no more than 80 percent of the appraised value of the home," Casey explains.
An appraisal typically is required to support the loan amount.
Borrowers also need good credit and an ability to document their financial assets and income.
"For an equity loan, they absolutely have to be able to document their income and money they have in the bank," Casey says.
The terms of the homeowner's first mortgage can also be a factor in qualifying for a second loan, particularly if the first isn't a regular fixed-rate mortgage.
For example, if a homeowner had an interest-only adjustable-rate mortgage, the payment could increase dramatically when the rate resets and the loan is recast. If that's scheduled to happen within five years, the lender typically will use the homeowner's projected future payment, rather than current payment to determine whether he or she has the ability to repay a new home equity loan.
"The terms of your first mortgage are something the lender will want to know about," Casey says. "They will look at the projected payments down the road."
Loan Docs Required
Like any home loan, a home equity loan involves certain costs that the homeowner will need to pay. These include an appraisal fee and escrow or settlement charges.
Home equity loans don't come in a no-fees format, but the costs can be paid for with the proceeds of the new loan, so borrowers don't have to save up the money ahead of time to get this type of financing.
Homeowners who have a lot of equity might expect a speedy process to get a home equity loan.
Typically, though, some patience is required as the lender's disclosures and documentation review can take as long as 30 to 45 days, about the same amount of time that's needed for a new first mortgage.
Borrowers should expect to review and sign approximately 30-to-40 pages of documents upfront and another 30-to-40 pages of documents at closing to get their loan, Casey says.
Among the many documents, borrowers should pay especially close attention to the Loan Estimate and Closing Disclosure forms, which explain the terms and fees of the home equity loan. Borrowers who have questions should ask for more information before they sign the paperwork.
With rates at historical lows, if you're considering a home equity loan and think you may be the perfect candidate, start shopping around now so you can get the best rate possible on your new loan.