Home Equity Loan

A home equity loan provides access to the equity in properties you own, using the funds for other purposes, such as increasing your real estate portfolio, paying a significant expense, or even debt consolidation.

You have equity in a property when you owe less on any property liens than the property’s value. To calculate the equity, subtract any loan amounts from the home’s current market value.

If your properties have equity, here’s everything you must know about a home equity loan.

What Are Home Equity Loans

A home equity loan is a loan against a property. You use the property as collateral to withdraw some of the capital you’ve invested in it.

You can earn equity in a property when you make payments on an existing mortgage or when the property value increases. You may even help the property value increase by making home improvements.

A home equity loan is a fixed interest rate second mortgage on the property. It’s separate from the primary mortgage and pays you the funds in one lump sum.

How Do Home Equity Loans Work?

If you determine you have equity in your property, you can apply for a home equity loan to withdraw the equity and use it for other purposes. Home equity loans often have fixed interest rates and work like installment loans with fixed monthly payments.

How to receive the home’s equity

You receive the home’s equity in one payment at closing. Upon approval, the lender will fund the loan if you’re refinancing a property you don’t use as your primary residence. If you borrow money from your primary residence, you’ll receive the funds in three business days to allow for the three-day cancellation rule.

Loan amount

Lenders depend on two factors when deciding on the loan amount you are eligible for:

• The property’s value
• Existing liens (if applicable)

Mortgage lenders typically allow a loan-to-value ratio of 80% to 90% of the home’s value, including any existing mortgage.

For example, if your property is worth $400,000 and you have an existing mortgage with a $100,000 balance, you could borrow as much as $220,000 to $360,000.

Loan term

The loan term for home equity loans varies by lender and what you can afford. You can find loans with terms of five years up to 30 years. The longer the term is, the more interest you pay in your monthly payment.

How to repay a home equity loan

Repaying a home equity loan is straightforward because the loan has a fixed interest rate. You pay the same principal and interest for the life of the loan.

As you choose your loan term, consider the monthly payment you can afford. A shorter term is great if you can afford the higher payment. If not, take the longer term, but consider making extra payments to pay the mortgage off faster and avoid additional interest.

Pros of Home Equity Loans

Before tapping into your property’s equity with a home equity loan, it’s essential to understand the advantages they offer.

Low interest rates

Most home equity loans offer lower interest rates than other consumer loans. This is because of the collateral you put up. Other loans, such as personal loans, are unsecured. This leaves the lender with no collateral if you default. In this case, the property is your collateral.

Easy to budget

Fixed monthly payments make budgeting much simpler. When you’re running a real estate business, predictability is good. The home equity loan payment becomes one of your operating expenses, so make sure there’s room in your rental income to add another debt.

Many terms to consider

You have a say in the loan’s term. Consider what you can afford and how long you plan to keep the property. If this is a long-term investment, you may want a shorter term to get a lower interest rate because most lenders reserve the lowest interest rates for shorter terms. However, if this is a short-term investment, a longer-term loan will leave you with more working capital as you figure out your next move.

You receive all funds at once

Unlike other financing options, you don’t have to wait to receive your funds. You receive everything in one lump sum and can use it or put it where you want. If you borrow a home equity loan on your primary residence, you’ll wait for the funds through the three-day right of rescission.

You can use the funds from a home equity loan however you want

Lenders don’t tell you how you can or cannot use the funds. You can use them to buy another property, consolidate consumer debt, pay a large expense, or keep them as an emergency fund. It’s entirely up to you.

Cons of Home Equity Loans

All financial decisions have a good and bad side. Here are the disadvantages of a home equity loan on your properties.

You put the home at risk of foreclosure

Anytime you put a property up as collateral, you risk losing it if you can’t pay. That’s why it’s imperative to determine what you can afford and not to borrow too much.

You must manage another monthly mortgage payment

If you have a first mortgage on the property, you’ll have two mortgages to handle. It’s not the end of the world, but you put your property at risk if you miss too many payments.

You must pay closing costs

You pay closing costs whenever you borrow funds to buy or refinance a property. The costs should be lower on a home equity loan, but they are costs nonetheless, taking away from your profits.

The closing costs may include the following:

• Appraisal fee
• Credit report fee
• Origination fee
• Title search fee

You must immediately repay the loan if you sell the home

Because the property is the collateral, you must pay the first and second mortgage off with the sale proceeds before you get any of the profits.

Home Equity Loan Alternatives

Accessing money from a property’s equity is possible with a home equity loan; however, there are alternatives to consider.

Home equity line of credit

Unlike a home equity loan that provides funds all at once, a home equity line of credit provides a credit line, like a credit card. You may receive some funds at closing if you request it, but typically you receive a credit line with a credit limit and access via check or debit card to use the funds.

Home equity lines of credit have variable interest rates, so your monthly payment is unpredictable. Your payment may increase or decrease depending on the funds you’ve used, the current interest rates, and your loan term. During the draw period, you’re only required to make interest payments but can pay the principal too.

You can draw funds as often as needed until you hit the max loan amount during the draw period. Your monthly payment can be unpredictable because HELOCs have a variable interest rate.

Cash-out refinance

A cash-out refinance refinances your first mortgage. Instead of only refinancing the amount you owe, you can borrow more money and receive it as cash at the closing or after the recession period on your personal property.

Cash-out refinance loans usually have lower interest rates because this loan is in the first lien position, putting the lender in a better position should you default.

A cash-out refinance is a good option when you can secure a lower interest rate than you currently pay and have the bonus of tapping into the home’s equity.

How To Get Home Equity Loans

You must meet the following requirements to qualify for a home equity loan. They will vary by lender, but this is what you can expect on average.

• Credit score: You’ll need good credit history and score to get a home equity loan. Most lenders want at least a 680 credit score, but you’ll get even better rates and a higher loan amount with a credit score of 700+.
• Debt-to-income ratio: Lenders like it when your debt-to-income ratio is 45% or lower. This means all debts, including credit card bills, mortgage, and personal loans, take up less than 45% of your gross monthly income.
• Equity: You must have adequate equity in the home to qualify for a home equity loan. Lenders differ on how much they will lend, but on average, you can borrow between 80% and 90% of the home’s current appraised value.

To get a home equity loan, you complete an application, usually online, and get a preapproval quickly. If you qualify, you must submit the required documentation to show you can afford the loan and have enough collateral to support it.

Learn More About Home Equity Loans

A home equity loan can greatly increase your real estate portfolio or help you in dire financial circumstances. Here are more resources to help you understand home equity loans.

3 Risks and Drawbacks of Using Home Equity When Investing

How I Went From 3 to 20 Properties Using the Power of Home Equity Loans

What is a Cash-Out Refinance