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How Does a HELOC Work & How Much Home Equity Do I Need for a Loan?
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One upside to owning a home is that you can start building equity. Once you pay off a certain percentage of your mortgage, you can use this equity to borrow money against your property by taking out what’s known as a home equity loan. This money is often used by homeowners to make repairs, pay down debt or invest in their education. If you are interested in borrowing against the equity you’ve built up in your home, learn more about how these loans work and how to qualify.
Lesson Notes:
- A home equity loan means borrowing against your home and using it as collateral.
- Typically, you need at least 15% to 20% home equity. A good credit score and low debt-to-income ratio can help you get approved.
- You may also need to submit proof of income, appraisals of the home and information about your mortgage.
LESSON CONTENTS
What is Home Equity?
Your home is one of your most valuable assets. If you have a mortgage, you don’t own your home outright, but you own a certain portion of it based on how much you still owe the lender. As you continue making your monthly payment, your equity in the home will increase.
To find out how much equity you have in your home, research the current market value of your home and compare it with how much you still owe on your mortgage. Check your monthly statement or log into your account online to find the principal amount of the loan. Divide however much is left on your mortgage by the current market value of your home. This leaves you with a certain percentage of home equity, also known as the loan-to-value (LTV) ratio.
For example, let’s say your home costs $250,000. Assume that you have been making regular payments over the years and have around $150,000 left on your mortgage. Divide 150,000 by 250,000, and you get 60%. That means you have an LTV of 60% and own approximately 40% of your home.
If you don’t have a mortgage or have already paid it off, you own 100% of your home with 100% equity.
What Are Home Equity Loans?
Home equity loans are issued by major lenders like banks and credit unions. When you take out a home equity loan, you are using your home as collateral. If you fall behind on your monthly payments or can’t pay back the money you owe, the lender retains the right to repossess the property. That’s why it’s important to make sure you understand how home equity loans work and find a repayment plan that works for you.
After closing on the loan and waiting for the rescission period to end, you have access to the funds. The repayment period can last anywhere from five to 30 years. Once you have closed on the loan, you will need to start making regular monthly payments plus interest every month.
Home equity loans tend to have lower interest rates than personal loans and credit cards. They come with fixed interest rates, which means the rate won’t change over the life of the loan.
The longer the repayment period is, the lower your monthly payment will be. However, the longer the repayment period, the more you will have to pay in interest throughout the life of the loan. Consider paying more than the required amount every month to avoid taking on unnecessary interest.
How Are They Different from HELOCs?
Home equity loans differ from home equity lines of credit (HELOCs). Both use your home as collateral and come with similar requirements, but they come with different terms and conditions.
A home equity loan is issued as a lump sum. The money may be deposited directly into your bank account, or you may need to set up a new account. You can then transfer this money or take out cash as you see fit. Since the loan is for a set amount with a fixed interest rate, your monthly payments will be the same every month, which makes it easy to plan out your finances. This is especially important considering your home could be at risk if you default on the loan.
A HELOC is a revolving line of credit, meaning you have a set credit or borrowing limit and can pull out money as you need it. The loan comes with a draw period, which usually lasts around five to 10 years. During this time, you are free to withdraw funds and use them however you please. You may be only required to pay the accrued interest.
At the end of the draw period, you will need to start repaying the money you owe plus whatever interest has accrued. The repayment period usually lasts for 10 to 20 years. If you need more time to pay back the principal amount plus interest, you may be able to apply for an extension.
Your monthly payment will vary month to month based on how much you’ve spent. HELOCs can also come with adjustable interest rates that fluctuate over time. The more money you use, the more you will have to pay the next month. However, you can also pay down the principal amount to free up additional credit. HELOCs are more flexible than home equity loans, but your monthly payment can fluctuate. You will need to monitor your spending to make sure you can afford your next payment.
What Are the Home Equity Loan Qualifications?
To qualify for a home equity loan or line of credit, you will typically need to have at least 15% to 20% home equity, however, the requirements vary by lender. If you are interested in applying, contact various lenders to see how much equity they require.
You may need more than just a certain amount of home equity to qualify. Some lenders may also require:
- A good credit score, usually a 680 or above.
- Low debt-to-income ratio.
- Steady income with enough to repay the loan.
- History of paying your bills on time.
Lenders use different criteria when lending money to homeowners. They want to make sure you can repay the money on time. Having a good credit score with a long history of paying your bills on time shows the lender that you are responsible with debt. You may also need to show them you are employed with a steady income.
You also shouldn’t have a lot of other outstanding debts. Your debt-to-income (DTI) is expressed as a percentage. Most lenders ask for a DTI ratio of 43% or below, which means your debts payments shouldn’t exceed 43% of your income. You should still be able to make regular monthly payments on top of your existing expenses, including your mortgage, car payment, student loan payment or credit card debt.
The more equity you have in your home, the easier it is to qualify. Some lenders may be willing to lend you money as long as you have a lot of equity, even if you don’t have a strong credit rating or payment history.
Are There Limits?
Yes, most lenders will only let you borrow up to 80% of your home’s overall value at a time. That means the remaining balance on your mortgage plus the amount of your loan must not exceed 80% of your home’s current market value.
To find out how much you can borrow, use a home equity loan calculator or multiply your home’s current value by 0.80. Now subtract how much you still owe on your mortgage, and you are left with the maximum amount you can borrow against your home.
For example, if your home is worth $250,000, 80% of its value would be $200,000. Your combined loan-to-value ratio (CLTV), which includes the remaining balance on your mortgage and the total amount of your home equity loan, must not exceed $200,000.
Contact the lender to see how much you can borrow against your loan.
What Do I Need for a Home Equity Loan?
You may need the following when applying for a home equity loan:
- W2s, pay stubs, bank account information, tax returns or some other proof of income.
- Mortgage information, including how much you still owe, recent appraisals of your home and records of all the mortgage payments you’ve made since you bought the home.
- A recent credit report (the lender will usually pull one on your behalf).
- Deed to the house.
- Copy of your homeowner’s insurance policy.
Be sure to prepare these documents ahead of time when applying for a home equity loan. Double check the lender’s requirements to make sure you qualify. Do your best to comply with the lender’s guidelines for submitting the paperwork. This will help expedite the process. Make yourself available in case the lender has any follow-up questions.
Use these tips to get approved for a home equity loan, so you can start spending today.
Ready to put your home equity to work?
Apply for a HELOC or talk to a Lending Specialist.
*PLEASE NOTE: This article is intended to be used for informational purposes and should not be considered financial advice. Consult a financial advisor, accountant or other financial professional to learn more about what strategies are appropriate for your situation.
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