How to Qualify for a Home Equity Loan in 2018
If you’re a homeowner trying to determine if you’re eligible for a home equity loan, this article will help. Home equity loans do come with some requirements, but we’ll show you exactly what you need to qualify, as well as some of the pros and cons of tapping your home equity for a loan and some alternatives if you decide it’s not right for you. By the end, you’ll have a good idea of whether a home equity loan is right for you or not.
- What is a home equity loan?
- Home Equity Loan Requirements
- Drawbacks to using a home equity loan
- Is a home equity loan right for you?
- Alternatives to a HEL
What is a home equity loan?
A home equity loan is money borrowed against the difference between the amount you owe on your home and the home’s market value. It is paid in a lump sum with a fixed interest rate and fixed monthly payments.
Another method of using equity is a home equity line of credit (HELOC). This is a line of credit, similar to a credit card. You only use the money you need, and you make monthly payments based on the amount of money you use.
You can use home equity loans to make home improvements, pay medical bills, cover the cost of college tuition or even to go on vacation. The money can be used for anything, but if you’re using the value of your home to pay for frivolous expenses, you may want to think twice.
Although the interest paid on a home equity loan was previously tax deductible, beginning in 2018 and running through 2025, the interest on your home equity loan is not tax deductible.
Even if you had a loan prior to the 2018 tax reform bill, you won’t be able to claim it as a deduction beginning in 2018, which may be a good reason to pay off that home equity loan sooner rather than later.
However, interest is still deductible on home equity loans if proceeds are used to substantially improve the residence. This may be a good reason to use your home equity loan for home improvements.
But Kim Paskal, CPA and tax shareholder at BeichFleischman says not to worry about it.
“Because of the rise of the standard deduction up to $24,000 for [taxpayers who are] married filing jointly,” she said, “not only are most people not going to take the HEL deduction, but you probably don’t even care if you get your mortgage interest deduction.”
That’s because unless you’re itemizing your deductions and they exceed the standard deduction amount ($24,000 filing joint, $18,000 for head of household and $12,000 for others), it wouldn’t make sense to take the deduction. In other words: Unless your charitable deductions, mortgage interest, and medical expenses are really high, chances are the non-deductible status probably won’t affect you.
Home equity loans also come with closing costs and fees to consider before you commit.
Home Equity Loan Requirements
In order to qualify for a home equity loan in 2018, you’ll need a few things.
- Equity. First and foremost, you need equity in your home in order to qualify for a home equity loan. Keep in mind your lender won’t allow you to borrow 100% of your equity. For example, if you had a $100,000 home with 20% equity — meaning you still owe roughly $80,000 — the most you could borrow would be around $10,000. Banks use loan-to-value (LTV) ratio to help determine exactly how much you can borrow and each one has different requirements. We discuss LTV in more depth further below.
- Loan-to-value ratio. Lenders use the loan-to-value (LTV) ratio to determine how much you can borrow. LTV is calculated by adding the amount you want to borrow with a home equity loan to the amount you owe on the home. Once you’ve got that figure, you divide it by the market value of the home. Below 80% is a good LTV to assure eligibility, but some banks allow for a higher LTV. For example, let’s say you’re looking for a $10,000 home equity loan and you owe $50,000 on your mortgage. If your home is currently valued at $100,000, that would give you an LTV of about 60%.
- Home market value. The market value of your home will help determine how much equity you have to draw on. In some cases, the lender may require an appraisal. You can get an appraisal yourself, or use LendingTree’s tool to determine how much your home is worth.
- Income. To qualify for a home equity loan, you’ll need to show you make sufficient income to cover the cost of your current debts, plus the additional debt you’ll be taking on. Having a low debt-to-income ratio will be important, too. For example, with Chase and Wells Fargo, you’ll need a debt-to-income ratio less than 43%. With TB Bank, it’s 43% to 49% depending on your credit score.
- Credit history. Your credit history includes the type of credit accounts you have, the balance on those accounts, and how long they’ve been open. It also includes your payment history and whether you have any late payments or collections on your account.
- Ability to repay. Lenders are required to put forth a good faith effort to determine your ability to repay a loan. To this end, a lender looks at your income, assets, employment, credit history and monthly expenses to determine your ability to repay.
Drawbacks to using a home equity loan
The biggest drawback to using a home equity loan is that it puts your house at risk. Because your house is used as collateral for your loan, if you fail to repay your debt, the lender may be entitled to force the sale of your home in order to satisfy your debt.
Another negative situation you may encounter is having your home drop in value after you’ve borrowed against your home. Because the equity you borrowed against is no longer available, you may have to come up with the cash to repay the loan.
Home equity loans also come with closing costs. So while the interest rate may be attractive, don’t forget that there’s an initial cost for borrowing.
Of course, there are many pros and cons you should consider before taking out a home equity loan.
Is a home equity loan right for you?
Paying for miscellaneous expenses that have no return may not be the wisest use of a home equity loan. Things like gifts or vacations are hard to justify when using your home’s equity. There may also be alternative ways to get the money you need.
But if you plan to budget for a needed expense, a home equity loan may be a very smart choice. Those may include medical expenses, college tuition or home improvements.
Like many other consumers, you may be concerned about how the 2018 tax reform bill will impact taking out a home equity loan. Mike Kinane, head of Consumer Lending for TD Bank has this to say about how home equity loans are being affected:
“While home equity loans and HELOCs may be impacted by the new tax reform legislation, they remain one of the best, lowest-cost options for homeowners who need funding for all types of things … We encourage customers to consult their tax advisors for guidance on the how the tax reform legislation will affect them.”
If you need money for one of those purposes stated above, use a home equity loan calculator to help you plan how much you can borrow and make the best decision for you. If you’re still uncertain about a home equity loan, let’s consider some other possible choices.
Alternatives to a HEL
Just like there are many alternatives to getting a reverse mortgage, there are are some alternative financing options to home equity loans.
Refinancing allows you to access your equity. You essentially replace your old mortgage with a new one and take the difference between the two in cash. While choosing between a cash-out refi and a home equity loan is tough, this article can help you decide what’s right for you.
Pros: Lump sum payment; lower interest rates.
Cons: Higher closing costs; starts your mortgage payments over.
Downsizing can allow you to access the money in your house. Essentially you sell a larger house for more than it will cost you to buy a smaller house. Then you can access the difference between the sales price of your old house and the price of new one to pay for whatever expenses you have.
Pros: Less house work; lower utility bills.
Cons: Less space for all your stuff; realtor costs.
Home equity line of credit (HELOC)
If you’re able to pay off your loan in a shorter period of time, a HELOC may be a better choice. This is because the adjustable interest rates on the HELOC may provide you with a lower interest rate initially, but is subject to increase as rates go up, meaning you could be paying a lot more in the future if you don’t pay it back quickly. HELOCs are not paid out in a lump sum and offer a line of credit where you pay only based on your balance.
Pros: Adjustable rates often lower than fixed rates; only pay interest on what you use.
Cons: Adjustable rates mean your payment can change.
Unsecured personal loan
Depending on your credit score and income, you may be able to take out an unsecured personal loan instead of borrowing from your home’s equity. An unsecured loan doesn’t require any collateral to secure the loan but may come with a higher interest rate because of this.
Depending on the amount of equity you have in your home, you may not be able to borrow as much with a personal loan as you could with a home equity loan.
Pros: Home is not used as collateral; no limitations on how the money is used.
Cons: Higher interest rate; limit to how much you can borrow; better credit required.
If you have enough equity in your home to get a home equity loan, it’s one of the best ways to borrow money.
For example, the rates on home equity loans are competitive when compared with credit cards and personal loans. One of the best ways to use the equity in your home is to make improvements to your home, but if needed, you can always use the money to pay other sensible expenses, like a child’s educational expenses or medical expenses. Just be careful about being able to pay it back, since your house is used as collateral.