What is a home loan and how does it work?

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A home equity loan allows you to borrow a lump sum of cash against the value of your home and pay it back with fixed monthly payments. (Shutterstock)

A home equity loan allows you to borrow a lump sum all at once when the value of your home is greater than your mortgage debt. Similar to a first mortgage, you pay off a home equity loan at a fixed interest rate over 10 to 30 years.

Here’s an overview of how home equity loans work, the costs typically associated with them, and the requirements you’ll need to meet to qualify.

Credible does not offer home equity loans, but you can compare pre-qualified mortgage refinance rates from several lenders in just a few minutes.

What is a home equity loan?

A home equity loan allows you to borrow against a percentage of your home equity, which is the difference between the market value of your home and the balance you owe on the home loans you already have. You can take out a home equity loan when you need a lump sum of money to cover a major expense.

Home equity loans are a type of second mortgage, and taking out a second mortgage involves risk. For one, your home will serve as collateral for the home equity loan. If you can’t repay the loan, you could lose your home. Your home also secures the first mortgage you used to purchase your home. If you take out a home equity loan in addition to your first mortgage, you will have two loans secured by your home, increasing your risk.

Increasing your monthly payment with a home equity loan will also tighten your budget. If your income drops, it may be more difficult to make your monthly housing payments than if you only had a first mortgage, or no mortgage at all.

How does a mortgage loan work?

A home equity loan, such as a cash refinance, allows you to borrow from your available equity. After closing your loan, you will have a three day right to cancel your loan if you change your mind. Once these three business days have passed, the lender will deposit the lump sum amount you have chosen to borrow into your bank account.

What you do next is entirely up to you. You could build a heated pool, replace your dilapidated roof, spruce up your yard, or pay off all your credit cards. You can also finance your wedding, make a down payment on an investment property, or send your child to college.

Whatever you do, just make sure you understand the benefits, risks, and trade-offs of your decision.

How much can you borrow with a home loan?

The amount you can borrow with a home equity loan depends on the equity in your home, your credit history, your income, and your existing debt. The more equity you have, the better your credit history, the higher your income and the lower your debt, the more you can borrow – and the better your interest rate will be.

Here’s how to calculate the equity in your home:

Home Value − Existing Home Loan Balances = Home Equity

For example, if your house is worth $400,000 and you owe $150,000 on your first mortgage, your net worth is $250,000.

Lenders often allow you to borrow up to 80% of the value of your home, or $320,000 for a $400,000 home. Your combined loan-to-value ratio (CLTV) is the sum of your first mortgage and the equity loan in the property you want to take out. After subtracting your first mortgage of $150,000 from $320,000, you would have $170,000 of equity available to borrow.

HOW TO REFINANCE A HOME EQUITY LOAN

Costs associated with home equity loans

The costs of taking out a home equity loan vary by lender, but here are the fees you can expect to pay:

  • Set-up or administration fees — A flat fee or a percentage of the loan amount to compensate the lender for underwriting and originating your home equity loan
  • Credit report — A nominal fee to the lender for purchasing a copy of your credit history and score
  • Evaluation – A fee to establish the value of your property to determine how much you can borrow
  • Preparation of documents — A minor charge to cover the cost of preparing your closing documents
  • Government registration fees — Your local government’s fees to officially document the new lien holder when you take out your home equity loan
  • Title search and report — A charge to ensure no one else has a claim on your property other than you and your current lender
  • Notary – A professional service fee to have someone verify your identity and witness your signature on your loan documents
  • Flood certification — A small fee to research if your home is located in a high-risk flood zone. If so, the lender may require you to purchase flood insurance.

Some lenders will waive some or all of your closing costs on a home equity loan to earn your business. However, if you refinance or repay the loan within three years of closing, you may have to repay the lender some of these costs.

You won’t find home equity loans at Credible, but if you’re looking for a great rate on a mortgage refinanceyou can compare rates from different lenders.

Advantages and disadvantages of taking out a home loan

Each financial product has its pros and cons. Here’s what you need to know about the pros and cons of a home loan:

Benefits of a home equity loan

  • Relatively low fixed interest rates
  • Ability to borrow a large sum
  • Flexibility to use the money as you wish
  • Potentially deductible interest, if you detail
  • Long repayment period

Disadvantages of a home equity loan

  • Requires a house as collateral, which increases the risk of foreclosure
  • May take several weeks to get the money
  • Interest rates are generally higher than the initial rates on home equity lines of credit (HELOC)
  • Tax savings likely won’t apply
  • Interest payments for a decade or more

HELOC vs home equity loan

Home equity loans and home equity lines of credit are the two types of second mortgage, but they work differently and meet different needs.

A home equity line of credit, or HELOC, gives you access to a certain amount of money that you can borrow as needed until you reach your credit limit. Your loan term begins with a drawdown period that typically lasts up to 10 years, followed by a repayment period that typically lasts another 10-20 years. You can use a HELOC to gradually remodel your home over time.

During the draw period of a HELOC, you can borrow and redeem your line at your leisure. Once the drawdown period is over, you can no longer borrow against your line of credit.

The interest rate is variable throughout the drawing period and the repayment period. However, some lenders will allow you to lock in the interest rate on some or all of the money you borrowed from your HELOC, similar to a home equity loan.

Depending on your needs, one loan may suit you better than another. Here’s how the two compare:

How to qualify for a home equity loan

Qualifying for a home equity loan is similar to qualifying for a refinance.

You will need to submit detailed information about your income, assets, and liabilities and back it up with information from account statements and tax returns.

A loan underwriter will review and verify everything to determine if you qualify.

Each lender has their own approval criteria, but typical requirements often include:

  • Credit score — At least 680
  • Debt-to-income ratio — No more than 43%
  • Home equity – At least 20%

If you decide that refinancing is a better fit with your financial goals, you can compare mortgage refinance rates from multiple lenders in minutes with Credible.

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