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What Is Home Equity — And How Can You Apply for a Home Equity Loan?


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Owning a house lets you build up home equity, which is a powerful thing.

More equity means more profit when you sell your house. You can also leverage your home equity and turn it into cash for things like home renovations, paying off debt or achieving other financial goals.

Do you want to know how you can use your home equity? This guide can help.

Table of contents

 

What is home equity?

Home equity is the difference between the market value of your home and the remaining balance on your mortgage. In short: It’s the stake in your home that you actually own.

Your equity changes over time. As you pay off your mortgage, your equity increases. If your home rises in value, your equity increases, too. (Conversely, if its value drops, so does your equity stake).

How does home equity work?

Home equity is based on your home’s value and the balances on any mortgages or loans you have against the property. So, as your home’s value increases or you pay down your mortgage’s principal balance, you build equity.

Once you’ve built up enough equity, you can use it by borrowing money from it through a loan or line of credit.

Home equity options

Your equity translates into profit when you sell your home. However, while you’re still living in the property, you can also borrow against that equity when you need cash.

There are three options for homeowners looking to do this: a home equity line of credit (HELOC), a home equity loan or a cash-out refinance. All three allow you to turn your equity into spendable funds, but they function slightly differently. Here’s what you should know about each.

Home equity line of credit

HELOCs let you turn a portion of your home equity into a line of credit. Much like a credit card, you can use the credit line as needed over time — up to your established credit limit.

Most HELOCs have a 10-year draw period, which is when you can withdraw and use the funds. During this time, you’ll typically pay only interest to your lender. After that draw period has ended, you’ll enter the repayment period, which is when you’ll start making full principal and interest payments until the loan is repaid. Since HELOCs often have variable interest rates, the cost of these payments can rise or fall over time.

With some HELOCs, you may have a balloon payment. This means the full balance comes due once your draw period ends.

Home equity loan

A home equity loan is more like a traditional loan. You’ll get a portion of your equity in a single, lump-sum payment after closing and then pay it back monthly over the course of five to 30 years.

Home equity loans usually have fixed interest rates, meaning your rate and payment will stay the same for your entire loan term.

Cash-out mortgage refinance

Cash-out refinancing is another way to leverage your home equity, but unlike your other options, this isn’t a separate loan. Instead, it replaces your existing mortgage loan — only with one that has a larger balance. That new loan pays off the old one, and you get the difference back in cash.

Since it replaces your existing mortgage, cash-out refinancing also means replacing your interest rate and terms, too. This may or may not be advantageous, depending on current interest rates.

Pros and cons of using your home equity

Leveraging your home equity can be helpful when you need cash, but there are drawbacks to consider, too. Make sure to consider the full spectrum of pros and cons before moving forward with one of these loans.

Pros of using your home equity

The biggest upside of using your home equity is that it’s typically more affordable than other financing options. Credit cards, for example, typically have rates that run well into the double digits, and personal loans have rates in the high single-digits.

Home equity loans, HELOCs and cash-out refinances, on the other hand, have much lower interest rates. So if you’d otherwise need to use a credit card or personal loan for whatever expense you’re facing, tapping your home equity could save you significantly on interest costs over time. (For these same reasons, home equity loans can also be a good debt consolidation tool, allowing you to pay off high-interest debt with a much lower-rate product.)

Another plus is that home equity products can potentially allow you to access a large amount of cash. Most lenders allow you to tap anywhere from 80% to 90% of your property value, minus your mortgage balances. So if your home is worth $500,000, and you only have $150,000 left on your current mortgage, you could potentially access up to $300,000 (500,000 x .90 – 150,000).

Cons of using your home equity

On the downside, using your home equity can be risky. For one, it reduces the profits you’ll get when you sell, and if your home decreases in value, it could mean owing more on the property than it’s worth.

Perhaps the biggest drawback is that it puts your home at risk of foreclosure. If you fall on hard times and are unable to make your payments, the lender could seize your house to pay off the debt.

Home equity loans vs. HELOCs

The biggest difference between home equity loans and HELOCs is that a home equity loan comes with a lump-sum payment, while a HELOC lets you withdraw funds over time. They also have different interest rate types and repayment schedules.

Here’s a look at how home equity loans and HELOCs differ.

Generally speaking, HELOCs are best if you’re not sure how much you need or if you need access to funds over an extended period. Home equity loans are a good choice if you have an accurate idea of what you need to borrow and you want a consistent, fixed payment that you can rely on.

 

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How to qualify for home equity products

Every loan product and lender has its own qualifying requirements. In all cases, you can expect your credit score, debt-to-income ratio, loan-to-value ratio and your equity to play a role.

Here’s a general look at what you might need to qualify for a home equity loan, HELOC or cash-out refinance, though it varies by lender.

Equity At least 10% to 20%
Credit score 620 or higher
DTI 43% or lower
LTV 80% to 90%

Keep in mind that these requirements can vary widely from one lender to the next, so make sure to shop around if you’re considering a home equity product. There’s a chance you may qualify with one company and not the next. Use our guides to the best home equity loans and the best mortgage lenders to get started.

How to apply for home equity products

Applying for a home equity loan, HELOC or cash-out refinance is much like applying for a traditional mortgage. You’ll need to fill out an application, agree to a credit check and submit various forms of financial documentation.

You also may owe closing costs, in many cases, and your home will need to be appraised too. This helps the lender confirm your home’s value, as well as how much equity you have to borrow from.

How to calculate your home equity

Calculating your home equity is a simple process. You take your home’s value and subtract the balance of any mortgages or loans against it.

So, for example, if your home’s valued at $350,000 and you have a $200,000 mortgage balance and a $50,000 home equity loan balance, you have $100,000 in equity. (350,000 – 200,000 – 50,000).

Home equity FAQs

How can you find the right type of home equity product for you?

The right type of loan really depends on what your goals are, your budget and the terms on your existing mortgage. If current interest rates are lower than what’s on your existing mortgage, a cash-out refinance may be best. If you need access to funds over a period of many years, a HELOC could be the way to go.

If you’re not sure, your best bet is to speak to a mortgage professional who can walk you through each option. They can also give you an idea of what costs to expect and how much you may qualify for.

How much do home equity loans cost?

The costs of home equity loans and other home equity products vary by lender. Typically, you can expect to pay around 2% to 5% of your loan amount in closing costs, but on home equity loans and HELOCs, some lenders will waive some or even all of these fees. It’s important to shop around for a lender to find the best deal.

You may also be able to finance your closing costs, which essentially rolls them into your loan balance. Just remember that this will increase your balance, as well as the long-term interest costs you pay.

What does equity in a home mean?

To have equity in a home just means that you own a stake in it. If your home is worth $400,000, for example, and your mortgage balance is $300,000, then you have $100,000 in equity (a 25% stake in the property).

What happens when you take equity out of your house?

When you take equity out of your home, you borrow against it — meaning use it as collateral. While this can allow you to access funds that you may need, it also puts your home on the line. If you fail to make payments, the lender could foreclose on your house.

Is a home equity loan the same as a mortgage?

A home equity loan is a type of mortgage. It’s technically called a second mortgage because it results in a second monthly payment (on top of your existing mortgage payment).

Any loan that uses your home as collateral is a type of mortgage loan, so this includes home equity loans, HELOCs and cash-out refinances. Reverse mortgages are also a type of mortgage loan.

What is the difference between home equity and your interest rate?

Your interest rate is the amount you pay to borrow money. So, if you have a 5% interest rate on your mortgage, you’re paying 5% of the loan amount annually to borrow those funds.

Equity, on the other hand, is the difference between your home’s value and the balances on your mortgage loans. The interest rate does not play a role in how much equity you have.

Is home equity the same as the value of a home?

The value of a home influences how much equity you have, but they’re not the same thing.

Home equity is a home’s total value minus the balances on any liens or loans against it. So, if your home is worth $400,000 and you have $200,000 in mortgage loans, you have $200,000 in home equity.

As a home’s value rises, the amount of equity you have does too. If the value of your home falls, though, you’ll actually lose equity.

Summary of our guide to home equity

Homeownership lets you build equity, which you can turn into cash with various financial products, like home equity loans, HELOCs and cash-out refinances. You can then put those funds toward home improvements, medical bills, college tuition or, as many consumers do, to pay off debt.

It’s important to shop around for a lender and consider all your options first. And if you’re not sure, consult a professional. A loan officer, mortgage broker or financial advisor can help you determine which option is best for your goals and budget.

Aly J. Yale is an experienced freelance writer and journalist, specializing in mortgage, real estate and housing. Her work has appeared in USA Today, Bankrate, Forbes, and Motley Fool, among other publications.



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