Understanding Home Equity Loans

Is your home is begging for an improvement or renovation? Even if you’ve read all the tips for a successful home renovation project, you might still be at a loss for the best way to finance your home improvements. Home equity loans are a common way many homeowners take advantage of their resources to make necessary improvements. Unlike many other financing options, home equity loans are secured against the funds you have already put toward paying off your house. Home equity loans might not be the right fit for everyone, but could be a smart financial choice if you’re looking for ways to find the money for home improvements. 

What Are Home Equity Loans?

As you make payments toward paying off your mortgage, you will accumulate home equity. Basically, home equity is the amount of your property that you have fully paid off and “own.” A home equity loan is classified as a second mortgage and comes in the form of either a home equity loan or home equity line of credit (HELOC). When you borrow against the value of your home, you’re taking a risk by offering your home as collateral in the loan process. If you fail to make payments, the lender can claim your house and put it into foreclosure. 

Home equity loan

A home equity loan is a form of installment credit. Typically distributed as one lump sum of money, a home equity loan is repaid monthly according to the terms agreed upon when the loan is secured. This kind of loan is beneficial for borrowers who have a large renovation to make, requiring a one-time, upfront payment as you’ll get your funds all at once. A normal repayment period for home equity loan repayment would be five to 15 years, according to The Balance. You should keep in mind your timeline will differ depending on how much you’re able to repay per month. 

Home equity line of credit 

This type of borrowing functions like a credit card in that it is revolving credit. A home equity line of credit gives users the ability to take out funds as needed, therefore avoiding unnecessary interest on loan money they aren’t using. The time in which you can take out money is called a “draw period,” and is established when you initially take out the line of credit. Typically, you are given a card, that looks like a credit or debit card, which you can use to make purchases against your line of credit. Repayment begins during the draw period, but monthly rates usually dramatically increase as soon as the period ends to move borrowers toward full repayment quickly. 

Qualifying for a Home Equity Loan

The first necessary qualification for obtaining a home equity loan is home equity. If you don’t have enough equity built up in your home, you won’t be able to borrow against it. Each lender will have different requirements for how much home equity you need, so be sure to check with the lender that holds your mortgage as your first step toward determining if you qualify. 

You’ll also need the following:

• Credit score of 620 or higher is a typical benchmark, according to BankRate
• Proof of your income
• Estimate of your desired loan value
• Qualifying debt-to-income ratio, usually between 43% and 50%, according to BankRate

Is a Home Equity Loan Right for You?

With different loan options available, it’s important to weigh the pros and cons of a home equity loan before you decide it’s the right financial option for you.

Considering the following factors will help determine if a home equity loan will save you the most money and be worth the risk of putting up collateral. 

Terms

The terms of your loan will include your interest rate, repayment period and other details associated with the loan itself and what your lender expects from you as a borrower. Terms also include extra fees and costs of the loan, which can add up, making it more expensive than you originally budgeted for. You’ll want to calculate your interest rate with your agreed payment period in mind, as a longer payment period means a greater overall loan cost. 

Interest rate

Interest rates on home equity loans come either as fixed or variable. Commonly, home equity loans have fixed rates which are repaid over a set time period with the same interest rate applying to monthly payments. More common for a home equity line of credit, variable interest rates can differ monthly.

According to ValuePenguin, the average interest rate for a home equity loan is a fixed 5.76 percent, and the average interest rate for a home equity line of credit is a variable 5.51 percent. These percentages exclude added costs and fees. 

Home value

Home equity loans are contingent on your property value and the amount you’ve already paid off. Consider your desired loan amount before proceeding with a home equity loan, as you might not have enough equity built up for this type of loan. 

Additionally, consider how the value of your home could change in the coming years. Are you planning to sell your home before you’ve fully repaid your loan? Are homes in your community losing value? If you decide to resell and lose money on your home, you’ll also be responsible for repaying the loan in full—making the remodel an out-of-pocket expense that you won’t even get to enjoy.

Closing costs and fees

Don’t forget to account for closing costs and fees when you take out your loan. On average, closing costs for a home equity loan range from 2% to 5%, which can be thousands of dollars depending on the value of your loan. Here are some additional fees associated with home equity loans to consider:

• Appraisal fee
• Origination fee
• Prepayment fee
• Title search
• Credit report fee
• Lawyer and documentation fees

Other Ways to Finance a Home Renovation

If you’ve decided that taking out a home equity loan isn’t right for you, don’t stress. There are several home financing options you can pursue. Here are two common choices. 

0% APR credit card

Putting your expenses on a no-interest credit card could be a viable route if you don’t expect to owe a lot of money upfront for the cost of your renovations. If you qualify for a 0% APR credit card, you won’t be charged interest during the promotional period of the card. On average, 0% APR credit cards have a period of 11 months interest-free, according to WalletHub. Terms differ depending on your lender and financial history. 

Remember, after the promotional period expires the APR on the card will increase. You’ll also likely owe interest on purchases starting from the date they were made, not the date the promotional period expires. That’s why you should only take out a 0% APR credit card if you have a payment plan to repay your spending before the end of the promotional period. 

Personal loan

If you don’t have the equity to get a home equity loan, a personal loan is a viable option. Since most personal loans are unsecured, if you fail to make payments, you don’t risk losing your home. They are also typically processed and approved quickly, within one business day in some cases. This is faster than a home equity loan, which can take a month or more to be finalized. 

However, keep in mind that interest rates are often higher than other types of loans, including home equity loans. Some personal loans are accessible to people with lower credit scores, but can be financially devastating if you can’t make monthly payments.