What is a Home Equity Loan and How Does it Work?
Home equity loans allow a homeowner to take out a loan against their equity in their own home. Think about these loans as a second mortgage. The property is used as collateral to secure the loan, and the lender will let you borrow up to the amount of equity that you have in the home. The loan will have a specific term with payments the borrower will have to make.
The popularity of home equity loans mainly increases due to 2 reasons; 1). Home prices go up in value and 2). Interest rates are low. Both of these things have happened throughout the United States since the pandemic began. There is some talk of interest rates being raised in 2022, and this also has motivated folks to lock in today’s low-interest rate pricing.
Home equity loans are being used in a variety of different ways. Some homeowners want the loan to make home improvements, which can enhance the value of the property further. The home improvement items purchased can also be used as a tax deduction against interest rates on the loan. Other uses of a home equity loan include paying off other higher-interest debt or investing the capital from the loan.
Unlike a home equity line of credit (HELOC), home equity loans are paid out as a one-time lump sum payment. HELOCs often have adjustable interest rates, meaning your debt payments will vary depending on the broader interest rate market.
How to Choose a Home Equity Lender
Before a borrower takes out a home equity loan, they may want to consider the lender they are working with. Lenders often have specific stipulations for borrowers to meet to secure a loan. Going over general lender requirements will usually help a borrower figure out what options they have.
Lenders need to examine the borrower’s finances in order to help determine whether the borrower can meet their debt obligation. Many lenders will require a borrower to have a minimum credit score of 620. Debt to income is another ratio the borrower will examine. This feature looks at a borrower’s monthly debt payments and divides them by their income before taxes. Many borrowers usually require a debt-to-income ratio of 43% or lower. Oftentimes these limits can widely vary depending on the lender. Borrowers that have stronger personal finances tend to have more lenders that are willing to give them a loan.
Once a borrower comes to terms with their personal economic reality, their next step will be to examine lending options. A key tool at a borrower’s disposal is the loan estimate tool. The loan estimate tool is a three-page report that lays out the exact terms of all the fees that will be assessed for a loan (interest rate, closing costs, and internal company fees). The Consumer Financial Protection Bureau requires lenders to share this document with all borrowers. The loan estimate tool is a way to make the terms of a home equity loan more transparent for a prospective borrower.
Outside of the specific terms of a home equity loan, the lender’s quality of customer service is an important consideration. Figuring out how to do a home equity loan can be a daunting task for a borrower that has never secured one before. A quality lending team should have a representative that can patiently walk the borrower through the necessary steps of securing a loan. For more information on comparing the best mortgage rates check out Lendstart’s expansive directory!
Average Home Equity Loan Rates by Market
MarketAverage RateAverage Rate Range
||3.50% – 4.50%
||3.00% – 6.19%
||5.50% – 9.25%
||4.13% – 6.45%
||5.99% – 5.99%
|New York Metro
||4.50% – 4.50%
||3.50% – 5.39%
||3.00% – 9.25%
What to Look for in a Home Equity Loan?
Borrowers may want to prioritize their important needs within a home equity loan. Below are some of the more common characteristics of a home equity loan, and some further information about why borrowers may want to take them into consideration.
- What is the lender’s average client? If the lender typically lends to less qualified candidates, the borrower may be missing out on an opportunity with a higher quality lender!
- How much equity is built up in the borrower’s home? The more equity the borrower has in their home, the more money they will be able to borrow. The borrower may evaluate the situation and decide to wait a bit to pay off more of the mortgage, or potentially for the value of the home to increase. Both of these things would build equity for the borrower.
- How long is the term of the loan? Deciding on how long of a time a borrower wants to make debt payments is an important consideration. Longer loans can offer lower monthly payments, but also more of a debt burden in the long run.
- What is the interest rate of the loan? As previously mentioned, lower interest payments are generally what a borrower is looking for. But at what cost? Is it worth paying off the loan years down the road to save a few basis points in monthly interest rate payments?
- What are the additional fees? Remember, lenders tend to offer additional fees outside of interest and principal payments.
- What are the risks in taking this home equity loan? Remember, the ultimate risk of not paying back a home equity loan is losing your home. Focusing on the needs for getting access to a loan rather than the wants can help mitigate the unnecessary risk that comes with a home equity loan.