Buying a house is an investment, one that can open opportunities in numerous areas of your life. Not only does it become a home for you and your family, you can also borrow money against the property, creating financial flexibility for a wide range of goals.You can access that flexibility is through a home equity loan (HEL) or home equity line of credit (HELOC).
When you take out a home equity loan, you receive a lump sum that you repay at a fixed interest rate.
With a home equity line of credit, you’re approved to borrow a certain amount, but you don’t need to use it all right away.
If you’re approved for $100,000, you might borrow in increments of $15,000 or $20,000, depending on your needs. Unlike HELs, HELOCs typically come with adjustable interest rates, though there are variations in the product terms you’ll want to compare to ensure you’re getting the best deal for your circumstances.
What it takes to qualify for a home equity loan
There are three key factors that impact your chances of being approved for a HEL or HELOC.
Decent credit. The first is your credit score. Because some lenders are more conservative than others, each will have different credit thresholds for approval.
“Getting a home equity is very similar to getting a mortgage,” Kelly Kockos, senior vice president in home equity product management at Wells Fargo, told MagnifyMoney. Borrowers will likely need at least fair to good credit to qualify for a home equity product, she says.
Substantial equity. The second element that needs to be in place is your available equity, which is determined by your existing mortgage balance and the total value of your home. If you’re approved for a loan or line of credit, the lender will decide how much of your equity you can borrow against. Depending how their products are structured, they may allow you to borrow up to 85% of your available equity. Most lenders won’t go above 85%, according to the Federal Trade Commission.
Tendayi Kapfidze, chief economist at LendingTree, says a good rule of thumb is to have a loan-to-value ratio that’s well below 80% before applying for a home equity product (Disclosure: LendingTree is the parent company of MagnifyMoney). He suggests that if a home is worth $100,000, a mortgage balance of $50,000 would be a healthy ratio for taking out a home equity loan or line of credit. Assuming a lender allows you to borrow up to 80% of your home value and that you meet all other criteria, you might be approved for up to $30,000 to use as you see fit.
Kapfidze says the percentage for which you’ll be approved depends on the lender’s criteria and the relationship you have with them. If you hold other assets with them, they may feel comfortable offering a higher loan or line of credit, he says. But regardless of where you apply, equity below 80% will provide enough of a gap between your remaining mortgage and your home’s value to borrow the money you need.
Low debt. Finally, lenders will take your debt-to-income ratio into account. As with other credit decisions, they’ll look at how much you pay each month on your mortgage, student loans, car payments and credit cards, Kockos says. Keeping these as low as possible will boost your chances of approval because a high debt-to-income ratio may raise red flags about your ability to manage another significant payment.
“If your debt is over 43% of your income, then it’s probably not a good thing for you to take on more debt,” Kockos said.
The benefits of home equity loans and lines of credit
Both HELs and HELOCs provide access to funds and offer a means to cover important expenses.
Kapfidze says that because home equity products are backed by your house as collateral, you’ll often secure better interest rates than you would through a personal loan or credit card. That’s why some consumers will use home equity to purchase cars or pay off student loans, because they’re able to secure better interest rates that way.
Whether you choose a home equity loan or line of credit depends on your particular circumstances.
Depending on how you use your loan, you may qualify for a tax deduction. You may choose to limit your home equity spending based on new tax limitations as well. The Tax Cuts and Jobs Act stipulates that you can only deduct interest paid on a home equity loan or line of credit if you use the funds to renovate, build or purchase the house that secures the loan, according to the IRS.
Who home equity loans are best for: Kockos says that home equity loans make sense for consumers who know they need a set amount of cash right away. If you’re facing a major expense with a set dollar amount — a medical procedure or a roof replacement, for instance — you may want to take out a loan for the exact amount you want to borrow. You can then lock it in at a fixed interest rate and you’ll know what your monthly payments will be for the duration of the loan.
Who HELOCs are best for: A home equity line of credit may make more sense if you want access to a certain amount of money but don’t necessarily want to use it all immediately. Unlike with an HEL, you’ll only pay on what you’ve already drawn from a HELOC. Kockos offers the example of using a HELOC to cover home remodeling expenses. You might be approved for $100,000 but you may not pay all of your contractors at once. Instead, you might pay $25,000 to one vendor this month and $10,000 to another next month. If that’s the case, you’d use your credit line as each expense comes up, and you only pay interest on the funds you’ve already drawn.
David Gorman, a division executive at Bank of America, says a home equity line of credit has become increasingly popular among both lenders and borrowers. “You very rarely see home equity loans anymore,” he said.
He attributes this shift to the flexibility of HELOCs. Even consumers who want to lock in a fixed rate can do so on their lines of credit, he explains. If you spend $30,000 of an $80,000 line of credit on roof repairs, you can lock in that $30,000 at a fixed rate to avoid significant interest increases during repayment. This provides some of the security of a home equity loan without sacrificing the benefits of the HELOC.
“It acts almost the same, and they don’t have to take it all out upfront,” Gorman said. “It provides you significant flexibility.”
The risks of home equity loans
The number one risk you must be aware of when you apply for a home equity product is that you’re borrowing against your home, and your lender can foreclose on it if you don’t make your payments.
“You’re risking your house, whereas with other types of loans, you may pay a higher interest rate but you’re not putting your house ‘on the line,’” Kapfidze said. Consumers should be well aware of that risk when applying for a home equity product, he added, but if they go into it with a full understanding of the terms, they’ll find that they are likely to get the best rates through these options.
Knowing that your house is at stake makes it vitally important to think carefully about how you spend your home equity funds. You can use the money however you choose, whether that’s to repair your basement after a flood or take a second honeymoon. However, paying for nonessential renovations or family vacations leaves you with less money to cover emergencies, not to mention with potentially significant debt that could become difficult to repay. Gorman says that Bank of America doesn’t advise borrowers on how to spend their money, but he says that misuse of funds is one of the biggest pitfalls that ensnare consumers.
“Should they actually need the equity in their house for other things down the road, they may no longer have it,” he said.
Shopping for a home equity loan
Look beyond the interest rate. The obvious comparison point when comparing HEL and HELOC offers is the interest rate. However, there are several other factors to consider as well. One is the fee — how much is the lender charging on top of your monthly interest payment? Another is whether there are rate caps in place to protect you against future interest rate spikes. Kockos recommends looking at annual and lifetime rate caps to determine which offers provide the best protection features throughout the life of the loan.
Compare flexibility. Kockos also suggests comparing product flexibility among HELOCs. Some lenders will offer lock and unlock features for their home equity lines of credit. This allows you to secure a portion of your spending at current interest rates but unlock it later if rates drop and you want to secure those instead. If your lender offers a lock and unlock option, be sure to ask how many times a year you’re allowed to use that feature so you’ll know how agile you can be based on rate volatility. Kockos notes that some lenders will offer promotions or discounts on fixed-rate home equity loans, so it’s worth inquiring about those as well.
Consider closing costs. Jorge Davila, vice president of sales, consumer direct and digital mortgage lending at Flagstar Bank, says it’s important to compare post-closing services as well. He recommends comparing when and how you’ll be able to access funds, whether there are mobile management options and whether there are prepayment penalties for your loan or line of credit. Factoring in servicing features along with rates and protections will give you a full picture of what you can expect from working with a lender.
What to do if you don’t qualify for home equity products
From a lender’s perspective, issuing a home equity loan or line of credit is riskier than giving someone a mortgage. Kapfidze explains that the mortgage lender has the first lien, meaning that they’ll be repaid first if you default on your loans. Because the home equity lender has the second lien and therefore carries more risk, their approval thresholds are likely higher. This means that your chances of qualifying for a home equity product may be lower.
However, if you still need access to a large sum of money, you may qualify for a cash-out refinance. In this case, you would refinance your current mortgage for a higher dollar amount that includes the remaining balance on the loan plus additional funds you can use for renovations and other needs. The difference between the two is what’s available for spending. Kapfidze notes that consumers can see higher interest rates on their refinanced mortgages than on their existing mortgages, so it’s important to be aware of the additional costs you’ll incur before pursuing this option.
Making the right home equity decision
The first step in applying for a home equity loan or line of credit is meeting with lenders. They can explain the qualification process so you’ll know exactly what to expect. But you’ll also want to dig into the specifics of their offers and get a sense of what it will be like to work with them. As with a mortgage, you may be repaying this loan over decades, so you want to make sure their terms and support options work for your needs. The right lender can help you determine how much to borrow and how to maximize the opportunities associated with home equity borrowing.
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