Owning your own home has many advantages, one of which is the leverage it gives you when you need to finance a major expense like a home improvement or debt consolidation. While non-homeowners are restricted to paying 10-20% interest for a personal loan, homeowners have the option of borrowing at 3-7% with a home equity loan in 2021.
A home equity loan is a fixed-rate, closed-end loan where the borrower uses their home equity as collateral. The loan is paid to the borrower in a lump sum and the borrower must pay back that sum, plus a fixed annual interest rate, within the pre-agreed repayment term. The usual repayment term for a home equity loan is 5-15 years, although some lenders have been known to offer terms of up to 30 years.
A home equity line of credit (HELOC) is an alternative type of home equity loan product with an open-end, revolving line of credit and adjustable interest rate. The borrower may draw funds at any time, provided they don’t exceed the approved credit limit. The borrower only pays principal and interest on the funds drawn. HELOCs usually allow up to 10 years to withdraw funds and a maximum of 20 years to repay.
Like a mortgage, a home equity loan or HELOC creates a lien on the borrower’s property, giving the lender the right to foreclose the property if the borrower defaults on payments. Usually, the home equity loan is the second lien on the property (after the initial mortgage), hence why home equity loans are nicknamed “second mortgages”.
Because a home equity loan or HELOC is structured like a mortgage, it involves closing costs ranging from 2% to 5% of the value of the loan (although lenders have been known to waive closing costs in exchange for a higher interest rate). Closing costs include origination fees, appraisal fees, title fees, and a bunch of other fees that homeowners will already be familiar with from their first mortgage.
The main eligibility requirement to consider before applying for a home equity loan is your combined loan-to-value (CLTV) ratio. In addition, home equity lenders usually look at the same things all other types of lenders look at when assessing borrowers, such as credit score, debt-to-income ratio, and payment history.
Most home equity lenders allow a maximum CLTV of 80% of 90% (although some credit unions may allow 100%). What this means is that your mortgage debts (home equity loan plus initial mortgage, if you haven’t paid it off) cannot amount to more than 80% or 90% of your home’s current value. Another way to think about this is that you must maintain at least 10-20% equity in your home based on its current appraised market value.
The keyword here is “combined”, which refers to the fact that all liens on your property are included in the calculation. Let’s keep things simple and say your home’s current appraised value is $400,000 and your mortgage balance is $200,000. In this case, your loan-to-value is 50%. If we take a max CLTV allowance of 90%, this means you can have up to $360,000 of debt on your home, leaving you a maximum permissible home equity loan amount of $160,000 after your mortgage balance has been factored in.
The most common alternatives to home equity loans are cash-out refinancing and personal loans. Home equity loans have certain advantages and disadvantages compared to these other options, so it pays to weigh up each pro and con to understand which option is best for you.
A cash-out refinance is when the new mortgage is greater in value than what you owe on the old loan, allowing you to cash out the difference. A cash-out refi usually involves a lower rate than a home equity loan but higher closing costs and fees. Therefore, if you’re only borrowing a smaller amount, a home equity loan is better. If you need to borrow a larger amount, a cash-out refi may be better.
An unsecured personal loan is the easiest way to get a loan because the application process is quick, and no collateral is required. However, personal loans are significantly more costly than home equity loans, and while they don’t involve the risk of foreclosure, they do involve the risk of higher monthly payments and potential damage to your credit score.
Interest rates for all loan products are near record lows in year, and home equity loans are no different. Based on a scan of our top home equity lenders, the best rates stand at around 3.25% for home equity loans and 2.88% for home equity lines of credit, while the average rate stands at around 6%. This compares to around 3% (but with much higher closing costs) for the average cash-out refinance) and 10-20% for the average personal loan (which varies heavily depending on your credit score).