What is a home equity loan?

Before proceeding with a home equity loan, you may want to understand the risks involved, assess your financial situation, and consider your borrowing needs.

How much home equity do you have?

Your home equity can be calculated by subtracting all debts secured by your home from your home’s current fair market value.

• For example, if your home is worth $400,000 and your current mortgage is $240,000, then you have $160,000 of equity in your home.

Your borrowing ability depends on your combined loan-to-value (CLTV) ratio. CLTV is your new loan amount plus your mortgage balance, divided by your home value.

• In the example above, you could potentially borrow up to $120,000 of your home equity with a lender that approves borrowing up to a 90% CLTV limit. This is because a new loan amount of $120,000 plus a $240,000 existing mortgage balance divided by the $400,000 home value is equal to a 90% CLTV ratio.

Monthly payments

Let’s say that, in this scenario, you want to take out a home equity loan of $50,000 with a ten-year term at 8% APR. You would make monthly payments of $606 over that period. Interest rates vary based on your finances and your lender, but this is how a home equity loan might look.

CLTV borrowing limits may vary by lender, and your borrowing ability will also depend on other eligibility factors, such as your credit score and debt-to-income (DTI) ratio.

READ MORE: What is a loan-to-value ratio and how is it calculated?

What are the requirements to qualify for a home loan?

Eligibility requirements for a home equity loan will vary by lender. As an example, Discover® Home Loans looks at several factors to determine if you are a qualified borrower, including:

• Equity in your home: You typically will need to have at least 20% equity in your home.
• Qualifying credit score: Lenders may require a credit score of around 680 to approve you for a home equity loan. The higher your credit score is, the more likely you will be approved for lower interest rates on your loan.
• Debt-to-income (DTI) ratio: Lenders often require a DTI below 43% to approve you for a home equity loan.

READ MORE: How to qualify for a home equity loan

Steps in acquiring a home equity loan

There are a few different steps to acquiring a home equity loan, such as:

1. Making sure you qualify: Lenders typically require 20% equity in your home, a DTI ratio under 43%, and a favorable credit score.
2. Shopping lenders: Different lenders may offer different rates for a home equity loan, so make sure you get the right rate for you.
3. Appraisal: Lenders usually appraise your home to verify your home’s value, and this often comes with a fee.
4. Gathering paperwork: You will need to provide paystubs, tax records, and any other necessary documents to verify your income and debt history.
5. Closing and signing your loan: At the end, you’ll likely pay closing costs that the lender charges and then sign your paperwork to receive your loan.

Pros of home equity loans

A home equity loan may be a useful financial tool for some homeowners. Some of the reasons why it can be beneficial include:

• Lower interest rates: Your home's collateral typically gives you access to lower interest rates than other forms of credit, such as personal loans or credit cards.
• Debt consolidation: Because of lower interest rates, using your home equity loan to consolidate debt and streamline payments may be beneficial for your finances.  
• Large loan amounts: Home equity loans may provide access to significant amounts of money, depending on the value of your home and the amount of equity you have built up.
• Flexible use of funds: You can use the funds from a home equity loan for many purposes, like home improvements, debt consolidation, or paying for major expenses like college tuition or medical bills.
• Tax-deductible interest: The interest paid on a home equity loan may be tax-deductible if the funds are used to buy, build, or substantially improve the home that secures the loan.

Cons of home equity loans

There are some potential downsides to borrowing money using a home equity loan that you should be aware of, including:

• Risk of foreclosure: Because your home serves as collateral for the loan, failing to make payments on a home equity loan can result in the loss of your property.
• Closing costs and fees: Home equity loans can come with closing costs and fees, which may be significant.
• Reduced home equity: Taking out a home equity loan reduces the amount of equity you have in your home, which may limit your financial flexibility and borrowing power in the future.
• Possible impact on credit score: Applying for a home equity loan will result in a hard credit inquiry, which may temporarily lower your credit score.
• Long terms: Large home equity loan sums often mean longer terms, which could accumulate more interest over time.

When does a home equity loan make sense?

A home equity loan may make more sense if you have built significant equity in your home, you want to consolidate payments, or you want to make home improvements. If you are looking for a smaller loan that doesn’t use your home as collateral, then a home equity loan may not be in your interest.

You may also want to consider interest rates. If they are low enough that you can repay the loan without preventing you from accomplishing your financial goals in the future, you may want to consider taking out a home equity loan. If these rates are too high, then you may consider waiting until they are lower or considering other loan options.