How do Home Equity Loans Work?
At times you need to borrow a sum of money, whether it is to consolidate debts, pay for a large home renovation, or another large purchase. For this, you have to look at all your options and decide which one is right for you.
One option is for you to opt for a home equity loan. A home equity loan is one that allows you to borrow money and use your home as collateral. You will receive a lump-sum payment and then repay the loan on a fixed rate interest over a predetermined term.
What Is A Home Equity Loan?
A home equity loan is where you borrow one lump-sum of funds, that you then pay back over the predetermined term at a fixed interest rate. You can only do this if enough equity is available to you.
Equity is the difference between the amount that you still owe on your home mortgage and its current market value. One way to grow your equity is to steadily pay your mortgage. You could also add value to your home through home improvements, this can often greatly improve your equity return. You also have to take into consideration the fact that markets can fluctuate, so your home may have increased in value since you purchased it. If you see a rise in the area's value it could mean that your equity has risen too.
Since your home is the collateral on an equity loan, any failure to make payments could put you at risk. If you are thinking about taking out a home equity loan, there are a few things you should know.
Thinking Of A Home Equity Loan?
A home equity loan could be a great way to finance some home improvements among other things. Were going to have a look at how they work below:
How Does A Home Equity Loan Work?
A home equity loan will give you a lump-sum of funds all at once. If you are aware of how much you will need and when you will need it, using it to finance a remodelling project with an already set budget, could make it the right choice.
You will repay the home equity loan; principal and interest each month, at a fixed rate over a set number of years. You need to be sure you can afford this second mortgage as well as your current one, on top of other monthly expenses.
How Much Can You Borrow With A Home Equity Loan?
You will find that a home equity loan enables you to borrow around 80-85% of your home’s value, minus what you already own on your mortgage. This means you can easily do a rough estimate of how much you may be able to borrow.
How You Can calculate A Home Equity Loan
Let’s say your home is worth $350,000, your mortgage balance stands at $200,000 and your lender will enable you to borrow up to 85% of your home’s value.
Multiply your home’s value ($350,000) by the percentage you can borrow (85% or .85).
That gives you the maximum $297,500 in value that could be borrowed
Minus the amount remaining on your mortgage ($200,000), and you’ll be left with the approximate sum you can borrow as a home equity loan, in this case, it would be $97,500.
If you’re not great at math, you can always use a home equity loan calculator.
Requirements For A Home Equity Loan
The requirements for a home equity loan will vary from lender to lender, but let’s have a look at three of the most common.
Have a debt-to-income (DTI) ratio of 43 percent or lower - Your DTI is one factor that a lender will consider when reviewing your application. The lower the percentage, the better. The qualifying DTI allowance will be different from lender to lender.
Have at least 15 to 20 percent equity in your home - The equity is the difference between how much your home is worth and the remaining mortgage. Lenders will utilize this number to calculate what’s known as the loan-to-value ratio, or LTV
Have a credit score in the mid-600s - Purely having enough equity isn’t the only consideration a lender will make. They will also assess you on your credit score. If you have a poor credit score it may be difficult to secure a home equity loan. Ideally, a score above 700 is perfect, however, homeowners with scores of 621 or more may qualify. If you think that a home equity loan may be suitable for you but your credit score isn’t hitting the mark, think about improving it and returning to the option at a later date.
To realistically value your home, your lender of choice may require an appraisal of your home to determine how much it’s worth and therefore how much you can borrow.
Deciding if a home equity loan is a right choice for you will depend on your financial situation and what your plan is for the money. You need to remember that using your home as collateral carries a large risk, so you should weigh all the pros and cons before you make the decision.
You get predictable payments because of the fixed-rate, this makes budgeting much easier.
It enables you to have a much lower interest rate than you may get from a personal loan or credit card.
You don’t have to give up your current mortgage rate, which is great if it is low.
If you plan to use it to make home improvements, they may be deductible.
In comparison to a home equity line of credit, it’s less flexible.
You will pay interest on the whole of the loan amount, even if you only use a bit at a time.
Any loan that you get against your house could have problems if payments are late or missed.
If you sell your home before the home equity loan is paid off, you will need to pay the balance back.
*Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are managed and may not be invested into directly.