When large expenses like major home repairs or college for your child start looming, you may start looking into home equity loans. If you are a homeowner with a significant amount of equity in your home, a home equity loan may be an option for you.
What is a home equity loan?
The equity you have in your home is the difference between what your home is worth on the market and what you owe to the mortgage company.
When you commit to a home equity loan, the lender provides you with the total sum of the loan upfront. It’s unlike a home equity line of credit, or HELOC, in which the lender provides an available source of funds that you can withdraw from as needed basis.
Although the need for immediate cash may overcome the risks, this type of loan comes with one large peril. When you take out a home equity loan, you are using your home as collateral. So, if you are unable to repay the loan, the lender may force you to sell your home as a way to pay for the loan.
What it takes to qualify for a home equity loan
Before you decide to pursue this type of financing, you may be wondering, “Am I eligible for a home equity loan?” Most loans have many requirements and home equity loans are not any different. Let’s review the requirements involved.
Equity. The first, and most important, thing that is required for home equity loans is that you have equity in your home. You can’t borrow the total amount of your equity — instead, the amount will be based on the lender and other factors about your application. According to David Krichmar, a mortgage banker in the Houston area, the biggest restriction on home equity loans is whether you have enough equity to access.
Home market value. You need to have an accurate estimate of how much your home would be worth on the market. Some lenders may require an official appraisal, while others may just calculate the market value based on your address and other details. If you aren’t sure where to start with an estimated market value, then consider using LendingTree’s home value calculator. Student Loan Hero is a LendingTree company.
Loan-to-value ratio (LTV). Lenders use the LTV of your home to determine how much you are able to borrow. A good benchmark for home equity loan eligibility is an LTV below 80%. Although many lenders offer loans to borrowers with higher LTV, you may not be getting the best interest rates if you have a less-attractive loan application.
To calculate the LTV of your current home loan, take your loan balance and divide it by your current appraised value. For example, if you had a loan balance of $90,000 and your home is appraised at $100,000, then you have an LTV of 0.90. When you convert that into a percentage, you have an LTV of 90%, which is higher than the typical 80%.
Income. In order to qualify for a home equity loan, you will need to provide proof of income to your lender. Your income is used to determine your debt-to-income ratio (DTI). If you have a DTI that is too high, then you may not be eligible for the home equity loan.
Most lenders require that your DTI be less than 43%, but some will allow for a higher DTI if you have a higher credit score.
Ability to repay. This one may seem obvious, but a lender is unlikely to underwrite a loan that you are unable to repay. A lender may assess your income, employment status, monthly expenses, credit history and more to determine if you are able to repay the loan or not.
Credit score. Solid credit history and a good credit score are typically required for home equity loans. Typically, a credit score of at least 620 will allow you to obtain a loan, but you may have to pay high interest rates. If you have a credit score higher than 700, then you are more likely to obtain a home equity loan with terms that are favorable for you.
Are there drawbacks to a home equity loan?
The largest drawback to a home equity loan is that you are putting your home at risk. In a home equity loan, you are using your home as collateral. The fact that your home is on the line creates a huge risk for anyone considering a home equity loan.
If you fail to repay the loan, then your lender may be able to force the sale of your home. The money from the sale of your house would go to the lender to satisfy your debt. The harsh reality is that some borrowers will default on their loan and lose their home in the process.
Krichmar recommends that you “make sure to take into account the costs involved for the new loan versus maybe a different path for the money.” Carefully consider whether this current financial crisis is a short-term problem or a long-term issue before taking out a home equity loan.
Another drawback is that your home could potentially lose value after you already have borrowed against the equity. If your home’s market value drops and the equity you have borrowed against is no longer a reality, then you will be forced to repay the home equity loan even though your home is no longer worth that much.
Is a home equity loan right for you?
Home equity loans for frivolous expenses are typically not a good idea in most situations. If you are planning to take out a home equity loan for a lavish vacation, then you may want to reconsider.
Casey Fleming, a mortgage advisor in Silicon Valley, suggested that good reasons for a home equity loan could include major home improvements, like a new roof, that you do not have the cash for right now. Or refinancing student loan debt in a way that allows you to replace an adjustable-rate loan with a fixed-rate loan or a substantially lower interest rate. However, according to Fleming, “using a home equity loan for debt consolidation is almost always a terrible idea.”
It all boils down to your specific financial situation and the options you have available for you.
If you are in need of the money and have a good reason, then carefully explore your home equity loan options. A good place to start is LendingTree’s home equity calculator, which can help you plan out how much you can borrow and more information about the best decision for your situation.
Once you have a good idea of the amount you can (or should) borrow, then compare the rates of many lenders before signing off on a loan. Make sure to read the fine print of any loan before you put your home up as collateral.
This article contains links to LendingTree, our parent company.