Consumers have many good reasons to take out a loan, and a home equity loan is sometimes the best way to get needed funds.
What you should know about home equity loans
The most important thing to understand about a home equity loan is that a default on the loan means that you lose your home and will be forced out of it. Here are a few more helpful details to help you decide whether a home equity loan is right for you.
What is a home equity loan?
For a home equity loan, the homeowner offers his equity in the home as collateral against the borrowed money. Equity is the amount your home is worth minus the amount, if any, that you owe on the mortgage. All outstanding loans and lines of credit are factored into the calculation.
Collateral is property that is pledged to a lender in exchange for a loan. Collateral provides a guarantee that the debt will be repaid. If the debt is not repaid, the lender has the right to take whatever was put up as collateral and sell it in order to get their money back. If you do not repay a home equity loan, you could lose your home.
When you take out a home equity loan, you receive a lump sum and then pay it off over a certain period of time. This type of loan has a fixed interest rate, which means that the rate will not fluctuate during the life of the loan. The payments are made monthly, and they are all the same amount. Once the loan is finalized, the amount borrowed does not change.
Another type of second mortgage is a home equity line of credit (HELOC). Anyone considering borrowing against the equity in his or her home should understand the differences between the two loan products. A HELOC is a line of credit, and the interest rate may change according to the prime rate. A HELOC is similar to a credit card in that you only borrow what you need, up to the limit, and you can take more cash out if you need to later on. See if a HELOC is right for you.
Home equity loan requirements
The primary requirement for securing a home equity loan is home equity. In times past, homeowners were allowed to secure loans of up to 110% of their home’s value. Not today. Lenders, in general, allow homeowners to borrow up to 80% to 90% of the value of their home. A few lenders allow homeowners to borrow 100% of their equity.
Credit scoring is another factor in securing a loan. It can be difficult to get a home equity loan with bad credit. However, experts say that applicants for home equity loans rarely have perfect credit. A typical minimum credit score required by lending institutions is 660. Other considerations contribute to loan eligibility, such as debt-to-income ratio (DTI).
A healthy debit-to-income ratio is in the low 40s or lower. That means that your total monthly debt obligations (minimum payments against existing debt) should equal no more than about 43 percent of your gross monthly income. Debt obligations might include auto loans, credit cards, student loans, other loans, housing and child support. Housing includes your mortgage payment plus property taxes, property insurance, mortgage insurance and any homeowners’ association fees you pay.
If Tom’s housing payment is $1,500, his car payment is $300, his credit card minimum payments equal $200 and his student loan payment is $300, his debt obligation is $2,300. If he earns $6,000 per month before taxes, his DTI is 38.3, which would be acceptable to most lenders.
Loan approval decisions depend on other factors, too. Home equity plays a major role. High equity might make it easier for a consumer with bad credit to qualify. In cases where a homeowner has a substantial amount of equity and a debt-to-income ratio that is higher than what is usually acceptable, the lending institution may make an exception to its DTI limit.
Best home equity loan rates
The best home equity loans are obtained at the best interest rates. Home equity loan interest rates are standard rates determined mostly by location. The home equity loan interest rate in effect when you sign the papers will be your rate for the life of the loan.
How does a home equity loan work?
If you are approved for a home equity loan and you sign the papers, you should know that in most cases you have a three-day cancellation period during which you can back out of the deal without penalty. You can cancel for any reason as long as your principal residence was used for collateral. Midnight on the third business day is the deadline for taking advantage of this consumer protection benefit provided by federal law. There are cases where the law does not apply; for example, when a state agency is the lender.
Home equity loan calculator
A home equity loan payment calculator makes it easy to see the numbers associated with a potential loan. Using a basic home equity loan payment calculator, you can enter the appraised value of your home, the total amount you currently owe in mortgages, and the loan-to-value ratio. If it has been several years since the last time your home was purchased or appraised, you may wish to have another appraisal done. The lender will require its own appraisal prior to finalizing the loan.