How to Get a Home Equity Loan
By Brandon Cornett | © 2014, all rights reserved | Duplication prohibited
A home equity loan allows you to turn a portion of your equity into cash. These funds can be used for a variety of purposes, including college tuition, vacations, remodeling projects and more. But how do you get a home equity loan? What are the requirements for this type of financing, and what steps are involved? Those are the questions we will address in this tutorial.
Get Quotes from Lenders
There's only one way to find out if you're qualified for a home equity loan. You have to apply. You can start the process online:
Audience: This article is intended for homeowners who are in a positive equity position. This is when your current home value is greater than your outstanding mortgage balance. Homeowners who are upside down in their loans are unable to get a home equity loan. Most lenders today will require you to have at least 20% equity in order to qualify for a home equity loan.
How to Get a Home Equity Loan (HEL) - By the Numbers
Let's start with an overview of the basic steps in the process. After that, we will get into a more detailed explanation of how to get a home equity loans. While the process may vary slightly from one borrower to the next, it usually goes something like this:
- Find out if you have enough equity to qualify for this type of loan.
- In order to do this, you need to determine the current value of your home.
- Equity is the difference between what you owe and how much the home is worth.
- The lender will have the home appraised to determine its current market value.
- Check your credit score. The lender will use this when assigning your interest rate.
- Get price quotes / offers from at least three different lenders (don't forget credit unions).
- Apply for your home equity loan and lock in the interest rate.
- Pay your closing costs, which are generally 2% - 5% of the amount borrowed.
- The new loan takes a lien position second to the first (hence, "second mortgage").
- You will receive your funds as a single, lump-sum payment.
- Repay the loan in regular installments over the agreed-upon term.
You may encounter additional steps that are not listed above, based on your financial situation. Let's talk about some of these items in more detail.
How Lenders Assign Interest Rates on HELs
How do lenders come up with their interest rates on home equity loans? Why do some borrowers qualify for better rates than others? The first thing you must understand is that mortgage lending is a highly individualized process. Every borrower is different. Lenders use a variety of tools to evaluate the potential risk a borrower brings. They price their loans based on the amount of perceived risk.
This is why lenders use credit scores when reviewing applicants and assigning interest rates. The credit score is a predictive tool used to measure risk. A higher score suggests a lower risk for the lender, statistically speaking. So they offer borrowers with excellent credit better interest rates than those with poor credit. (See step #5 above, under "How to Get a Home Equity Loan.")
The bank will also consider your combined loan-to-value ratio, or CLTV, when pricing the loan. Generally speaking, a borrower with a lower CLTV will qualify for a better rate on a home equity loan. We will talk more about this below.
There are other factors that affect the rate you receive. These include the type of property you own, your geographic location, the size of the loan, and the length of the payback period (term).
How Do Home Equity Loans Work?
We've covered the basics of how to get a home equity loan. Let's shift gears now and talk about why people use this type of financing. HELs allow you to turn a portion of your ownership into cash, which you can use for a variety of purposes. They are also referred to as second mortgages, because they are used once you actually own the house, and also because the HEL will occupy a second-lien position behind the first mortgage.
Many people use these loans to pay for home improvement projects, college tuition, or other expenses where a single, lump-sum payment makes the most sense. But you are not limited to these things. You can use the money for almost anything. The question you must ask yourself is whether or not it makes sense to do so.
In a sense, home equity loan rates are a secondary consideration. The first thing you need to consider is the amount of risk involved. Remember, you are using your house as collateral. So you stand to lose it in the event of default.
Turning Equity Into Cash
In this context, equity can be defined as the difference between (A) the current value of your home and (B) the amount you still owe on your mortgage, plus any other liens you might have. If your house is currently worth $300,000, and you owe $200,000 on your mortgage, then you have $100,000 worth of equity in the property. To state it differently: You own one-third of your house, and the bank owns the other two-thirds. You are leveraging the portion you own as collateral for additional financing.
We've just identified one of the key aspects of how to get a home equity loan. Your home must be worth more than the existing balance on your mortgage. You cannot leverage something you don't have. I've repeated this concept several times in this article for a very good reason. It's the primary disqualifier when it comes to HEL financing. There are two reasons for this:
- Lenders today have higher LTV regquirements for home equity loans.
- Most Americans who have owned homes for at least the last five years have also lost equity, thanks to the housing crisis.
Homeowners who owe more on their mortgages than their homes are worth (i.e., underwater / upside down) would not be able to use this strategy. They have no equity to tap.
There are two ways to turn your equity into cash. You could use a home equity loan (HEL) and receive the funds as a single lump-sum payment. Or you could open a line of credit (HELOC) and use the funds as needed, much like a credit card. In this tutorial, we will limit our discussion to home equity loan rates in particular. I've mentioned the HELOC to avoid confusion. They are not the same thing.
Home equity loans typically have a fixed rate of interest. This means you pay the same interest rate for the entire term of the loan. Most of these loans have a term of 5 - 15 years, but they can be longer. Since the interest rate stays the same, the monthly payments remain fixed as well. You will make the same sized payment at predetermined intervals, for the entire life of the loan. This is an important distinction from the HELOC option mentioned earlier, which typically has a variable interest rate.
How Much Can I Borrow?
Your home equity loan rate will partly depend on the size of your loan. So how much can you borrow? Lenders use different formulas when setting these limits.
For borrowers with excellent credit, lenders may be willing to offer up to 85% of the appraised value of the home, in the form of a home equity loan (minus the amount owed on your mortgage). For example, let's assume a borrower's home is worth $300,000. He still owes $140,000 on his mortgage. Eighty-five percent of $300,000 is $255,000. When we subtract the mortgage balance (140K) from that amount, we end up with $115,000. This is the amount the homeowner would be able to borrow in the form of a home equity loan, using this particular model. The amount you borrow will also affect the rate on your home equity loan.
Current Trend: 85% of CLTV
These days, many lenders are using the combined loan-to-value ratio (CLTV) to determine how much they are willing to lend. And most have become stricter with their guidelines, as a result of the housing crisis that began in 2007. If you apply for a home equity loan today, there's a good chance the lender will limit you to borrowing 80 - 85% of your CLTV.
To determine this number, the lender will first consider the current market value of your home. Next, they will factor in whatever loans / liens are outstanding on the home. They will take the total of these outstanding principal balances and divide it by the value of your home. This is your combined loan-to-value ratio. Now take 80 - 85% of that number, and you'll have a pretty good idea what a lender might be willing to give you. This is another factor that will affect your home equity loan rate.
Generally speaking, you will need a combined loan-to-value (CLTV) ratio of 85% or less, in order to qualify for HEL financing. In other words, the amount you wish to borrow, combined with your current mortgage balance(s), should not exceed 85% of your home's current value.
This will make more sense when we plug some actual numbers:
A Loan-to-Value Scenario
Let's say my home is worth $250,000, and I owe $120,000 on my mortgage balance. In this scenario, my LTV ratio is 48%. So I have a ways to go before I reach the 80 - 85% mark. This means I will likely qualify for a home equity loan, as long as I meet the lender's other requirements such as credit scores.
If I took out an equity loan for $75,000, my CLTV would go up to 78%. Here's how I ended up with this percentage: $120,000 mortgage balance + the new loan of $75,000 = $195,000. Next, the $250,000 home value divided by $195,000 = 78%. This is still below the limit set by most lenders. An HEL of $90,000 would put me at a combined loan-to-value ratio of 84%, so I might be able to qualify for a loan up to this amount (if the lender follows the 85-percent rule).
In most cases, a higher CLTV ratio will result in a higher home equity loan rate, and vice versa. This is one of the factors lenders use when pricing their loans.
Note: These requirements are not set in stone. While they represent current trends in the lending industry, exceptions can be made for well-qualified borrowers. So it never hurts to apply, even if you fall below the equity level mentioned above. And if you do fall below this level, you might want to consider applying with a credit union. In some cases, their LTV requirements are less strict than the big banks. Some borrowers are able to get a home equity loan through a non-profit credit union, even after being turned down by a regular bank. It's a fairly common scenario, actually.
Conclusion and Summary
Homeowners use home equity loans to convert ownership into cash. The amount you will be able to borrow will depend on the amount of equity you currently have in your house, as well as the current market value of the property. At the top of this page, you'll find a link where you can get home equity loan quotes from lenders. The interest rate you receive will depend on your credit score, your combined loan-to-value ratio, the length of the payback period, and other factors.
Equity loans bring a certain amount of risk. Most notable among them is that the lender could sell your home if you fail to repay the loan. This type of financing can also lead to a downward debt spiral. If you use the money from your HEL to make additional purchases, you will have even more debt than before. Of course, if you are using the loan to pay off credit cards and reduce your total interest costs, you could come out ahead in the long run. Just keep in mind that a credit card company cannot take your house -- but a mortgage lender can!
If you are a responsible borrower, and you know what you're getting yourself into, a home equity loan might be a sensible strategy. It could provide you with a much-needed source of funds. You just need to go into it with your eyes wide open. For this reason, we highly recommend that you continue your research beyond this website.
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