If you want to consolidate debt or pay for a big expense, you may be considering digging into your home equity. A home equity loan is a type of second mortgage that allows you to borrow against your home and receive cash in a lump sum.
Due to the economic uncertainty caused by COVID-19, many lenders have stopped offering home equity loans. Click here for alternatives.
What makes a home equity loan unique?
Unlike a HELOC, which is a type of revolving credit like a credit card, you receive a home equity loan in a lump sum. It’s a true loan, and not a line of credit.
Fixed interest rate
Home equity loans have fixed interest rates, meaning that the amount of interest you pay is not at the mercy of the market. This can be a good thing or a bad thing, depending on how your fixed rate compares to the market rates.
Why would I get a home equity loan?
Many homeowners will use a home equity loan to renovate their houses. This makes sense, because renovations will only increase the value of the home, thus helping you build equity long-term. Additionally, interest on a home equity loan used for home improvements can be tax-deductible.
Pay off debt
You could also use a home equity loan to pay off all your debt, similar to how you would use a debt consolidation loan. This can be tricky, though. If you can’t repay the home equity loan, you risk losing your home. It can also cause issues with discharging the debt if you decide to file for bankruptcy.
Unexpected expenses may prompt you to use a home equity loan instead of a credit card or personal loan. Low interest rates can make this appealing, but again, weigh these decisions carefully — your home could be on the line.
How much can I borrow?
The percentage of your home’s value you can borrow depends on your lender’s maximum allowed combined loan-to-value ratio, or CLTV. The max CLTV is the percentage of your home’s value you are allowed to borrow.
For example, let’s say that your home is worth $175,000. Your lender has a max CLTV of 82% and you currently owe $45,000 on your mortgage. Here’s how you would calculate how much you could borrow:
(Max CLTV) x (Value of your home) = (CLTV value)
0.82 x $175,000 = $143,500
(CLTV value) – (What you currently owe) = (How much you can borrow)
$143,500 – $45,000 = $98,500
In this situation, you could borrow up to $98,500. However, you should only borrow what you need. If you take out too much, it will gather interest even if you don’t use it.
How do I qualify?
Different lenders have different requirements, but there are some general standards you can reference.
In general, you should have…
- At least 15-20% equity.
- A debt-to-income ratio (DTI) of 43% or less.
- At least a 620 credit score.
- An appraisal of your home, in some cases.
Now, these aren’t hard and fast rules. You’ll need to talk to your lender about your specific situation. But these are good benchmarks to measure yourself against.
How do I repay a home equity loan?
Home equity loan repayments happen in installments. You pay monthly for a term between 5 and 30 years.
Pros and cons
Home equity loan pros
- You don’t have to deal with variable interest rates.
- You get the money all at once.
- If you use the loan for home improvements, the interest may be tax-deductible.
Home equity loan cons
- You could lose your home if you can’t repay.
- You could borrow too much and owe high amounts of interest.
- The market interest rate could drop, leaving you stuck with a higher fixed rate.
- It’s not as flexible as a HELOC.
If you need cash…
Home equity line of credit (HELOC)
Another way to use your home equity to get cash fast is with a home equity line of credit, or HELOC. It’s a revolving line of credit, so you can use it like a credit card instead of taking out a lump sum. Unlike a home equity loan, a HELOC has a variable interest rate that is affected by the market.
If your credit score is good enough, you could also apply for a personal loan. The amount you qualify for and your interest rate will depend on your credit report.
If you can’t qualify for an unsecured personal loan, you could also try using one of your assets as collateral to get a secured personal loan. Or, you could have a family member or friend cosign on a loan for you.
If you need to pay off debt…
Debt consolidation loan
A debt consolidation loan is an unsecured personal loan used to pay off all your debts at once. This consolidates all of your monthly payments into one payment with a lower interest rate.
A balance transfer is a type of credit card. You transfer all existing credit card debt onto this card, which usually has a 0% interest rate for a limited time. As long as you can pay off all the debt before the promotional period ends, you won’t rack up any more interest. However, if you don’t pay it off before the 0% interest times out, you will get hit with a high interest rate all at once. Be careful with this DIY debt consolidation method.
Your initial consultation with a credit counselor is usually free, especially if you work with a nonprofit agency. A certified credit counselor’s job is to help you find the best debt relief solution for your situation. Ideally, you will fit the bill for a debt management program (DMP). In a DMP, you work with a credit counselor to repay everything you owe. Your total interest payments will be lowered and you will pay off your debt faster than you would on your own.
When you settle your debt, you agree to pay less than what you owe. This is one of the fastest methods of getting out of debt, but it will hurt your credit score. You can settle your debt on your own or work with a reputable debt settlement company.
Bankruptcy is often seen as a last resort, but if the amount of debt you’re carrying is just too high for you to ever feasibly repay it, then it could be a viable option. It will hurt your credit score, but also give you a clean financial slate. Before jumping right into bankruptcy, consider talking to a credit counselor. There may be a better option for you.