Published by Bankrate

Written by Hanneh Bareham

If you need cash for a home renovation or other large expense, you might be considering tapping your home equity. Two of the main ways to do that are home equity loans and home equity lines of credit (HELOCs).

Equity loans: Overview
Also known as second mortgages, equity loans allow borrowers to borrow money via their home’s equity, the difference between the home’s current market value and the borrower’s remaining mortgage balance.

Equity loans come in two main forms: Home equity loans and HELOCs. With both, your equity acts as collateral for the lender, so if you fail to make the monthly payments, you run the risk of losing your home.

Home equity loans operate like mortgages with fixed, monthly payments and can be used for any expense, including home improvement projects, financing a college education, debt consolidation or long-term investments. HELOCs are lines of credit, making them useful for larger, long-term renovation projects, and typically come with a variable interest rate, but some lenders offer fixed-rate options.

With either, the amount you can borrow is generally based on loan-to-value ratio (LTV) or combined LTV ratio (CLTV) — how much you’re borrowing compared to the value of the property — with a typical limit of 80 percent or 85 percent of your equity. Your specific limit might be based on factors such as credit score, annual income and payment history.

Because equity loans are secured by your home, they tend to have lower interest rates than unsecured forms of debt, like credit cards or personal loans.

Eligibility requirements for equity loans
While criteria can vary by lender, these are the general requirements for a HELOC or home equity loan:

A debt-to-income (DTI) ratio of no more than 43 percent
A good credit score, at least in the mid-600s
A sufficient, steady income
A history of on-time payments
At least 15 percent to 20 percent equity in your home
Home equity lines of credit (HELOCs)
A HELOC is an equity line of credit similar to a credit card — you can borrow up to a certain amount and take out however much you need, when you need it, and for any purpose. The interest rates on HELOCs are variable, but some lenders allow you to convert some or all of your balance to a fixed rate.

Typically, HELOCs have a draw period of 10 years and a repayment period between 10 years and 20 years. During the draw period, you can access the funds and are only required to make interest payments (though you can make interest and principal payments if you choose). During the repayment period, you can’t access the funds anymore, and are responsible for making both interest and principal payments.

Home equity loans
Home equity loans are secured loans backed by your home’s equity. They almost always come with a repayment term between five years and 30 years and a fixed interest rate. Home equity loans are funded in one lump sum and can be used to finance any project, investment or purchase. If used for home improvements, the interest might be tax-deductible (more on that below).

Home equity loans vs. HELOCs
Home equity loans seem similar to HELOCs, but they are different ways to borrow money.

Home equity loan HELOC
Interest rates Fixed Variable
Loan terms 5 years to 30 years 10-year draw period; up to 20-year repayment period
Repayment Begins once funds are disbursed Interest-only payments during draw period; interest and principal payments during repayment period
Funding Disbursed in one lump sum amount Withdraw any amount, up to the limit, when needed
Monthly payments Same payment every month Varies based on interest rate and balance owed
Pros Lower rates compared to credit cards and personal loans; potential interest deduction Can borrow only as much as you need; possible option to convert to fixed rate; potential interest deduction
Cons Can only borrow a fixed sum, which might be more or less than you need; risk of foreclosure if you can’t repay Variable rate means your payments might go up; risk of foreclosure if you can’t repay
Equity loan tax deductions
Joint filers can deduct the interest on up to $750,000 of qualified loans, including equity loans, if taken out after Dec. 15, 2017. Single filers can deduct the interest on up to $375,000 worth of qualified loans.

Joint filers whose loans closed before Dec. 15, 2017 can deduct the interest on up to $1 million, while single filers in the same situation can deduct the interest on up to $500,000. These deduction limits apply to all mortgages.

Equity loans vs. refinancing
When you refinance, you take out a new mortgage to replace your previous mortgage, with the new loan ideally at a lower rate or otherwise better terms. There are two main types of refinancing: rate-and-term and cash-out. A cash-out refinance is similar to an equity loan in that it allows you withdraw some of your equity as cash, but differs in that you’ll replace your current mortgage instead of getting a second one.

Generally, refinancing is best for borrowers who can get a lower interest rate and plan to stay in their home long enough to recoup the closing costs. An equity loan is best for those who want to retain their existing mortgage (typically because they have an attractive rate) but still need funds.

How to get an equity loan
1. Review your credit and finances
Before applying for an equity loan, check your credit. If you have a lower score or an inconsistent payment history, it’ll be harder for you to get approved. If needed, take steps to improve your score, such as paying down or paying off debt. Speaking of debt, calculate your debt-to-income (DTI) ratio, as well. Remember most lenders look for a DTI ratio of no more than 43 percent, though some might allow up to 50 percent.

2. Calculate your equity
To qualify for an equity loan, many lenders require you to have at least 20 percent equity in your home — in other words, a maximum LTV (or CLTV) ratio of 80 percent. To calculate your home’s equity, take your current mortgage balance and subtract that from your home’s value. You can also use Bankrate’s equity calculators:

HELOC calculator
Home equity loan calculator
Note: Lenders rely on an appraiser’s opinion of your home’s value to determine how much equity you’re allowed to tap. If you’re just weighing your options, however, you don’t have to hire an appraiser — you can talk to a real estate agent or use an online home price estimator tool to get a rough idea of how much equity you have.

3. Compare home equity lenders
Not every mortgage lender offers home equity products, and to get the lowest rate, it’s crucial to shop around. Many banks provide home equity loans, and some online lenders do, too. To help narrow down your options, review home equity lender reviews and testimonials. Once you find the lender that meets your needs and offers the best rates, check its eligibility requirements to make sure you qualify.

Equity loan payback help
If you’re having trouble making your equity loan payments, contact your lender as soon as possible. Your lender might offer relief like a lower rate, adjusted repayment terms or forbearance options. Don’t wait to miss a payment before contacting your lender — if you do, eventually, you’ll be given a notice a default and the lender might begin the foreclosure process.

Bottom line
While borrowing from your home’s equity can be a risky move, if you can afford the payments, equity loans allow you to borrow large sums of money at relatively lower rates. If you’re unsure whether to borrow a HELOC or a home equity loan, talk to a lender. You might also want to speak with a financial advisor to help determine which option best suits your situation.

https://www.bankrate.com/home-equity/home-equity-guide/#relief

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