What Is a Home Equity Loan?

09.16.2022 | Category: Homebuying

If you are looking into renovating your home to increase its value, or you want to augment your source of retirement income, a home equity loan may be the right choice for you.

Borrowing funds for whatever purpose you need can be simpler and easier this way. But what are the steps you need to take? Starting with the basics of what a home equity loan is, how it works and how to apply for one, to what the home equity loan credit score minimum is to qualify, this blog can answer those burning questions you may have.

Equity is the difference between your property’s current market value and your remaining mortgage balance. For example, let’s say your house is worth $300,000, and your mortgage balance is $200,000. So, your home equity value is $100,000.

$300,000 - $200,000 = $100,000

A home equity loan is a consumer loan that involves borrowing against the equity you’ve built up for your home. Also known as a second mortgage, this loan allows you to convert your home’s equity into cash.

How Do Home Equity Loans Work?

Based on the sample figure above, you have built your equity up to $100,000. This consists of the total amount you have paid and is an asset to you. It could be a combination of your down payment and monthly mortgage repayments.

Now, let’s say your property was worth $300,000 when you purchased it. Factoring in the rising home prices today, you may assume your home’s value may have gone up, with your equity also growing.

Let’s take the average 2022 price of homes in the United States, which is almost $350,000. Given the example that your property increases its value up to the current national average of $350,000 – and your mortgage balance remains the same at $200,000 – you then get:

$350,000 - $200,000 = $150,000

What Is a Home Equity Loan Used For?

People have varying purposes for taking advantage of a home equity loan. The money you receive from your home equity loan allows you to fund anything, from home renovations to retirement.

Let’s look at some of the most common reasons for borrowers going this route:

Home Renovation

The first purpose is home improvements. Many homeowners take advantage of this situation since the interest on a home equity loan used for this purpose is tax deductible. At the same time, renovating the home can significantly increase a property’s value.

So, make sure to follow the guidelines provided by the Internal Revenue Service:

[The loan should] buy, build or substantially improve [your property].

Debt Consolidation Home Equity Loan

Home equity loans have lower interest rates than other consumer debt, such as credit cards. So, people may leverage it to get out of debt and reach their financial goals.

In debt consolidation, a home equity loan is used to pay off other forms of debt. But here, you also risk losing your home if things don’t go as planned.

Investment

Home equity loans offer a straightforward application process. This makes it suitable for those who want to invest in a small business, especially those just starting out.

In addition, this type of consumer loan can also prove valuable to those planning to invest in the stock market.

Retirement Fund

Retirees may have spent decades building equity in their homes. So they now have the option to borrow against it to augment their retirement income.

Home Equity Loan Credit Score Requirements

While it seems simpler and more straightforward to get a home equity loan, you still have to meet the following requirements during your application:

A certain percentage of equity in your home: As mentioned earlier, this should be at least 20% for banks and lenders to improve your chances of getting approved.
Home equity loan credit score minimum: A good credit standing is a green flag for lenders. You will most likely qualify for a loan if you fulfill the above requirement and have a credit score of 680 or higher. But most lenders prefer homeowners with credit scores of 700 and above, while others will still consider those with a score of 621 to 679.
Other criteria: There are a few other requirements for would-be borrowers, such as a low debt-to-income ratio (DTI), sufficient income, and reliable payment history.

Pros and Cons of Home Equity Loans

Now that you know what needs to be fulfilled in your application for a home equity loan, it’s time to understand the benefits and risks associated with it.

The pros of borrowing against your equity include the following:

Like your first mortgage, this second mortgage comes with a fixed interest rate. This means you will know how much to pay each month for a designated period of time. For example, your monthly repayments will not be affected by rising interest rates in the future.
Not only are the interest rates fixed, but they are also lower than other consumer loans like credit cards.
The process is quite simple because it is a secured debt. Meaning that you put up an asset as collateral – in this case, your home – and the lender will have the legal right to exercise a lien on your property, which could also be a con if you cannot complete your repayments.

On the other hand, here are the cons of taking out a home equity loan:

You will receive a lump sum payment, which may result in taking out more than necessary and spending the remaining amount impractically.
You risk foreclosure should things turn out for the worse.
Moving or selling your house may not be possible if your home’s value declines.
It may be challenging to keep up with your payments in the future if you take on more today.

How To Find the Best Home Equity Loan

We provided you with an idea of how the process can pan out by listing major home equity loan credit score requirements. Moreover, we touched on the advantages and disadvantages of a home equity loan.

Given everything you know about this consumer loan, have you decided on whether or not to pursue this path? If you said yes, it’s time to prepare yourself for the risks involved. It’s never too early to find a financial advisor or mentor to assist you throughout the steps.

You can use our multiple mortgage calculators to determine if you are financially ready and able to take on a second mortgage. Specifically, you may check how much you will pay monthly using our loan payment calculator.

At Mutual of Omaha Mortgage, we assist homeowners in understanding the various ways they can obtain financing for their home, including the home equity loan. Our experts have decades of experience and a proven track record behind them. We help you plan for your second mortgage application while crunching the numbers to bolster your confidence and chances of getting approved.