A home equity loan is a personal loan secured by the value of your residence. It’s often the easiest form of personal credit for individuals to get. While requirements will vary, most lenders will extend a loan to borrowers who have more than 15% equity in their house and a credit score of 650 or above. Consider working with a financial advisor as you look to use home equity to borrow.
What Is a Home Equity Loan?
A home equity loan resembles a mortgage. The lender will issue you a lump-sum payment, meaning that you receive the money all at once, with the amount based on the value of the underlying property. You then repay that loan on a set schedule and interest rate.
In most cases a home equity loan comes with a fixed interest rate (meaning that it does not change once the loan has been issued) and payments occur monthly. Interest rates tend to be lower than with other forms of personal lending because the loan is secured by your house.
This also creates a risk. Just like with a mortgage, if you default on a home equity loan you can lose title to your house. This can happen in a number of different ways. With minor loans (that is, a loan which represents a smaller portion of the home’s overall value) the lender may simply put a lien on the property. However, in severe cases the lender may foreclose and sell the house, taking the balance owed.
Unlike with some mortgage programs there are no residency requirements with standard home equity loans. You can use any property so long as the lender feels that the value of the property justifies the loan.
Requirements to Get a Home Equity Loan
Every lender will have different requirements when it comes to issuing a home equity loan. However, many of these stipulations are remarkably similar to those of a mortgage itself. Here are a some of the major terms that most lenders will hone in on:
At Least 15% – 20% Equity in Your Home
Equity is the amount of your home that you own as opposed to the amount you owe. For example, say you bought your house for $400,000, and you have paid $75,000 on your mortgage after making a $25,000 down payment. You then have 25% equity in the property, as you still owe the remaining $300,000 in the home’s value.
Most lenders require you to have at least 20% equity in your home before they will extend a home equity loan. Many will not lend past the 20% equity mark, meaning that between your home equity loan and mortgage combined they do not want you to owe more than 80% of the home’s value. Some will issue a loan if you have at least 15% equity in your home, but it is rare for legitimate lenders to issue a loan to someone who owns less than that.
Never borrow more than the value of your home even if the lender is willing to write the loan.
Less Than a 36% Debt-to-Income Ratio
Your debt-to-income ratio is the ratio of how much money you pay each month on existing debts compared with how much money you make each month. For example, say you earn $5,000 per month. You also pay $1,000 per month on credit cards, student loans and car payments combined. Your debt-to-income ratio would be 20%.
Most lenders in most circumstances look for a debt-to-income ratio of around 36% or less before they’ll extend a new line of credit. This isn’t a hard and fast rule, but it’s pretty common. Home equity loans are the same. Given that this is a secured loan, lenders may be more forgiving than usual on this requirement, but expect most of them to at least start at the 36% standard.
Credit Score of “Fair” or Better
Credit is very flexible here. Ordinarily, a lump sum personal loan requires high credit and exacting standards. Lenders aren’t exactly lining up to hand over a bag of unsecured cash. However, since this is a secured loan, they’re willing to accept far looser standards.
Every lender is particularly different when it comes to credit on a home equity loan. However, as a general rule, expect your lender to look for a credit score in at least the mid-600s. Some may go down as low as 620 or 640 before they raise a red flag. This is good news for potential borrowers with weak credit, but only sort of. You might get the loan, but with a credit score below 700 you should also expect to get saddled with a very high interest rate.
Home Equity Loan vs. HELOC
There are two main types of loans that you can take out with the equity in your house: a home equity loan and a home equity line of credit (HELOC). They are similar, but not identical.
A HELOC is, as the name suggests, a line of credit. This works just like a credit card. (In fact, a credit card is a line of credit.) You have a maximum amount that you can borrow at any given time. You can borrow and make payments on this line of credit based on its terms, so long as you never currently owe more than the maximum allowed. This is an ongoing form of lending.
A home equity loan is a one-time loan. You receive a lump sum amount up front and then make payments over time. If you want more money you must apply for another loan. For this reason it’s common for home equity loans to be somewhat larger than HELOCs.
What to Watch Out For
Home equity loans are an area where borrowers should beware. This industry is one that often encourages predatory behavior. It is common for lenders to be much less interested in getting payment than in getting your house. This isn’t a general warning against home equity loans. Just be careful before you borrow from an unknown lender and be particularly careful before you borrow from a lender with loose terms. If someone has a “No Credit, No Problem” sign on the front door, you will almost certainly be better off talking to your neighborhood bank.
And if you’re looking for a loan with weak credit, it can’t hurt to look into your state’s usury laws. Many dishonest lenders try to saddle borrowers with high interest payments in an intentional effort to push the borrower into default. This writer has represented clients on exactly this issue.
To learn more, the FTC has a fact sheet on how to spot good and bad lenders. Dishonest home equity lenders are an issue for law enforcement in every state, so if you think you’ve been swindled don’t hesitate to contact your local attorney general’s office or a lawyer.
Home equity loans are lump sum loans that you take out and are secured by the value of your house. You make payments on a fixed interest rate and schedule, the same way you would with a mortgage, and they can be an excellent way to access high value lending for individuals. However, make sure you fit the requirements for getting a home equity loan, as doing so too early will likely mean you’ll get denied.
Tips on Financing
- Big-ticket lending is a powerful tool, which means we should use it with respect. In the right circumstances a major loan can help you secure another property, boost the value of an old one, access investments and even go to school. But what are the right circumstances? A financial advisor can help you figure that out. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s no-cost mortgage calculator to estimate your monthly mortgage payment with taxes, fees and insurance.
- SmartAsset’s free mortgage comparison tool to compare mortgage rates from top lenders and find the one that best suits your needs.
Photo credit: ©iStock.com/alexsl, ©iStock.com/courtneyk, ©iStock.com/courtneyk