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What is a home equity loan?

A home equity loan is a fixed-rate loan you take out to borrow cash in a lump sum for a set repayment period. Home equity is the difference between your mortgage balance and your home’s current value. 

A home equity loan may also be called a second mortgage because it’s placed in “second” position behind your original home loan. Common features include fixed-rate payments for the life of the loan, and terms between five and 15 years.

How does a home equity loan work?

Borrowing against home equity is similar to getting a regular mortgage. The basic loan process and qualifying requirements include:

  1. Submit an application. To get your best rates, compare estimates from at least three to five lenders.
  2. Provide income documents. You’ll need to prove enough earnings to qualify for the loan.
  3. Get a credit report. The credit score for a home equity loan should be at least 620, but some lenders may require an even higher score, often between 660 and 680. You may snag your best rates with a score of 740 or higher.
  4. Check your debt-to-income ratio (DTI). This is a measure of your total debt divided by your gross monthly income, and lenders prefer a DTI ratio of 43% or less. Some lenders may allow a DTI ratio of up to 50% in some cases.
  5. Get a home appraisal to verify equity. A home appraiser provides an unbiased opinion of your home’s market value. Home equity lenders typically won’t lend more than 85% of a home’s value and order an appraisal to confirm your home’s value. This is also known as the home equity loan LTV (loan-to-value) ratio.
  6. Closing costs. Total closing costs for a home equity loan range between 2% and 5% of the loan amount. 

Home equity loan vs. a home equity line of credit (HELOC)

A home equity line of credit (HELOC) is a revolving credit option for tapping home equity that works like a credit card. During a set time frame called the draw period, which typically lasts 10 years, cash can be withdrawn and paid off as needed. The payment is based only on the amount used. 

Here are some key differences between a home equity loan versus a HELOC:

Home Equity Loan vs. HELOC
Home Equity Loan HELOC
Interest rate is typically fixed. Interest rate is usually variable.
Money is received in a lump sum. Cash can be used as needed.
The monthly principal and interest payment is fixed for the life of the loan. The monthly payment is based on the amount drawn.
May offer an interest-only payment option.
After the draw period ends, the balance is paid in fixed monthly payments.
Closing costs are paid out of pocket or from loan proceeds. Closing costs are paid out of pocket or from loan proceeds.
Besides standard closing costs, annual membership and transaction fees may apply.
There may be a fee for closing out the line.

Top 5 reasons to get a home equity loan

Take advantage of low interest rates
Make improvements that add value to your home
Get cash for a large purchase
Pay for college
Consolidate debt

Should you get a home equity loan?

A home equity loan is best if you prefer a fixed monthly payment and know how much money you need for a home renovation or a specific financial goal. Despite the benefits of home equity loans, there are also risks to consider.

Pros

  1. It’s good for covering large home improvement projects. Plus, mortgage interest paid on a home equity loan used for renovations is tax-deductible.
  2. It can be used for any purpose like replacing high-interest revolving debt with a fixed- and lower-rate payment.
  3. Get money in one lump sum when needed at rates often lower than other types of financial products, such as credit cards or personal loans.

Cons

  1. Rates and payments are higher at first than a HELOC.
  2. You can lose the home if you default on the loan because your house secures the debt.
  3. You can’t deduct mortgage interest if you use the loan for purposes other than home improvements.