A home equity loan is a type of secured loan in which the borrower uses their home equity as collateral. Home equity loans are also known as “second mortgages” because they are secured against the home’s value, just like a regular mortgage. A home equity loan creates a lien against the borrower’s home and reduces the borrower’s home equity. As the borrower makes payments, their home equity begins increasing again. A home equity loan usually has a shorter repayment term than a traditional mortgage.
There are two types of home equity loan products: a closed-end or home equity loan, also known as a HEL; and an open-end or home equity line of credit, also known as a HELOC.
A HEL is like any other type of closed-end loan in that the lender pays the borrower a lump sum which the borrower must repay within an agreed payment term. Closed-end HELs come with a fixed interest rate, giving the borrower the convenience of knowing up front how much they are required to pay the lender each month.
A HELOC is a revolving line of credit with an adjustable interest rate. The borrower may draw funds at any time, provided they don’t exceed the approved credit limit. The borrower only pays principal and interest on the funds drawn.
The basic requirement of a home equity loan is that you own your own home. At most, lenders permit homeowners to borrow up to a combined loan-to-value (CLTV) ratio of up to 90% (although some credit unions may allow 100% CLTV). In other words, a lender will not approve you for a home equity loan if it means your home equity drops below 10% of your home’s current appraised value. Generally, home equity loans can only be taken on owner-occupied properties, although it is technically possible to use a rental or investment property as collateral.
Aside from CLTV, all the other minimum requirements of mortgage or loan eligibility apply. You will need to be a U.S. citizen or resident aged 18 years or more. The lender will run a credit check, which will affect your credit score. And you will need to provide some paperwork, although less than for a traditional mortgage application.
Technically speaking, a home equity loan can be used for any large expense. This could include consolidating credit card debt or other debt; funding an unexpected bill, such as an unexpected medical procedure; financing a home improvement or refurbishment; purchasing a vehicle; or funding a child’s college tuition.
Generally, a home equity loan is best used for anything that improves your financial position, such as paying off debts or boosting your home’s value. Let’s say you’re struggling to keep up with payments to three separate credit card providers, all of which are charging high interest. With a home equity loan, you could pay off all those debts immediately and now start paying your home equity lender – at a lower rate and lower monthly payments.
Like any secured loan, a home equity loan or home equity line of credit carries certain risks. Before applying for a home equity lending product, you should always think wisely and do your own calculations.
The first thing to think about is which is more suitable for your needs: a HEL or HELOC. If you need a lump sum for a large payment, a HEL is best. If you need frequent, small sums, a HELOC is best. It works like a credit card but with better rates.
Another thing to consider is the purpose of the loan. As we mentioned above, home equity loans can technically be used for anything – but that doesn’t mean you should use them recklessly. When the housing market crashed in 2007-8, many homeowners found out the hard way what it means to have a lien against one’s home. When you secure a loan with your property, that gives the lender permission to seize the property if you default on the loan. When taking a home equity loan, always take caution against over-extending.
In many ways, HELs and HELOCs are direct competitors to personal loans. Both involve borrowing money from a lender and using the funds for whatever purpose you need.
HELs and HELOCs are secured loans in which the borrower takes on some of the risk from the lender. As a result, home equity lenders generally offer far superior rates than personal loan lenders. In 2019, the average home equity loan rate was less than 6%, whereas the average person loan rate was around 11% and the average credit card interest rate was around 17%.
Unsecured personal loans don’t offer the benefits of home equity loans, but they also don’t carry the same risks. With an unsecured loan, there is no risk of having your home foreclosed or seized by the lender.
A home equity loan is one way of using your home ownership to finance a home improvement or major expense. An alternative way is a cash-out refinance, which involves converting your mortgage into a new, larger mortgage – and cashing out the difference between the two loans, minus closing costs and fees.
A cash-out refinance usually involves a better rate than a home equity loan, but higher closing costs and fees. Therefore, if you’re going for a smaller amount, a home equity loan is better. If you’re going for a larger amount, you may want to consider a cash-out refi. The exact decision depends on your home equity and your loan amount and on how much you’re able to afford in monthly payments. If you’re unsure which of the two options is best for you, it’s always wise to compare the numbers before deciding.
So, you’ve decided to take a home equity loan or home equity line of credit. Before you agree to anything, go ahead and compare a few lenders. To begin, this site provides a comparison chart and reviews of top lenders to help you compare rates, terms, minimum requirements, and more. To compare pre-qualified rates from multiple lenders, use a loans marketplace like LendingTree or go ahead and apply directly to several lenders. Once you see pre-qualified rates from 3-5 lenders, you should have a fair idea of what sort of rate you’re eligible for and which lender is the best fit for you.