For homeowners, your house is likely one of your most valuable assets. The equity you build as you pay down your mortgage gives you financial power and options. One way to leverage your equity is through a home equity loan. This type of financing allows you to borrow against the equity in your home for various uses. But how exactly does a home equity loan work? Let’s take a closer look at what home equity loans are, how you can use them, and the loan process.
What is a Home Equity Loan?
A home equity loan is a type of loan that uses your home as collateral. Specifically, it allows you to borrow money against the equity you’ve built up in your home.
Home equity is calculated by taking your home’s current market value and subtracting the amount you still owe on your mortgage. For example:
- Your home’s current market value: $400,000
- Remaining mortgage balance: $200,000
- Your home equity: $400,000 – $200,000 = $200,000
With a home equity loan, a lender will lend you money up to a certain percentage of your available equity. Typically lenders limit loan amounts to 85% loan-to-value to protect their investment and your equity.
The loan provides you with a fixed amount of money, usually as a lump-sum, which you pay back over a set repayment term with fixed monthly payments. It works similarly to a mortgage or auto loan.
How Do You Use a Home Equity Loan?
Some of the most common uses for home equity loan funds include:
- Home improvements – Kitchen/bath remodels, swimming pool installation, roof replacement, deck additions and more.
- Debt consolidation – Pay off higher interest credit card, medical, or personal debts all at once.
- College tuition – Tap equity to help pay tuition rather than taking out parent PLUS loans or private student loans.
- Business financing – Access capital for business expenses without giving up business equity.
- Emergency expenses – Draw from home equity to cover unforeseen costs like medical bills or repairs.
- Life events – Finance expenses related to weddings, adoption, fertility treatments, and more.
- Investments – Use the funds as investment capital for real estate or other ventures.
The Home Equity Loan Process
If a home equity loan aligns with your goals, how do you go about getting one? Here are the general steps in the process:
- Check your home equity – Determine how much untouched equity you have available to borrow against by examining your latest mortgage statement and researching your property value.
- Check your credit score – Most lenders want at least a 620 credit score to qualify, but you’ll get better terms with a score over 700.
- Research lenders – Compare options from banks, credit unions, and online lenders. Look for the lowest rates and fees.
- Complete your loan application – You’ll need to provide financial docs like bank statements, tax returns, and your mortgage balance.
- Home appraisal – The lender will hire an appraiser to evaluate your home’s current market value.
- Underwriting – The lender will verify your financial qualifications and collateral value to approve your loan.
- Closing – Once approved, you’ll sign final loan documents and the lender will disburse the loan funds.
Throughout the process, pay close attention to interest rates, fees, loan terms, and monthly payments to make sure the loan fits your budget and needs.
Advantages of Home Equity Loans
- Fixed rates from 5% – 8% typically, lower than credit cards or personal loans
- Fixed monthly payments provide predictability
- Interest may be tax deductible (consult a tax pro)
- Taps into your equity without having to sell
- Quick access to large lump sums
Considerations Before Borrowing
While home equity loans offer many perks, they aren’t right for everyone. Before applying, think carefully about:
- How much equity you want to retain
- If you can manage the monthly payments
- Your timescale for repayment
- Your other debts and expenses
- Your job security
Home equity debt also increases foreclosure risk if you fall behind on payments. So make sure to borrow conservatively and that repayment aligns with your income and budget.
Unlocking home equity through loans can provide homeowners with an affordable way to finance major expenses, complete home improvements, consolidate debts, and more. Just be sure to weigh the risks and benefits for your individual financial situation. When used strategically and with caution, conventional loans can be an accessible way to leverage the equity you’ve built in your most valuable asset.
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