Today we’re going to talk about the “home equity loan,” which is quickly becoming all the rage with mortgage rates so much higher.
In short, many homeowners have first mortgages with fixed interest rates in the 2-3% range.
Now that a typical 30-year fixed is closer to 6%, these homeowners don’t want to refinance and lose that rate in the process.
But if they still want to access their valuable (and plentiful) home equity, they can do so via a second mortgage.
Two popular options are the home equity line of credit (HELOC) and the home equity loan, the latter of which features a fixed interest rate and the ability to pull out a lump sum of cash from your home.
What Is a Home Equity Loan?
A home equity loan allows you to borrow against the value of your property to access needed cash.
That cash can then be used to pay for things such as home improvements, to pay off other higher-interest loans, fund a down payment for another home purchase, pay for college tuition, and more.
Ultimately, you can use the proceeds for anything you wish. The home equity loan simply allows you to tap into your accrued home equity without selling the underlying property.
Of course, like a first mortgage, you must pay back the loan via monthly payments until it is paid in full, refinanced, or the property sold.
Similarly, you can obtain a home equity loan from a bank, credit union, or direct mortgage lender.
The application process is comparable, in that you must provide income, employment, and asset documentation, but it’s typically faster and less paperwork intensive.
Additionally, your credit report will be pulled to determine your credit scores and overall creditworthiness.
Home Equity Loan Example
|Property Value $650,000||First Mortgage||Home Equity Loan||Cash Out Refinance|
Home equity loans are typically second mortgages, taken out by an existing homeowner who already has a first mortgage.
This allows the borrower to access additional funds while maintaining the favorable terms of their first mortgage (and continue to pay it off on schedule).
Imagine a homeowner owns a property valued at $650,000 and has an existing home loan with an outstanding balance of $450,000. Their interest rate is 3.25% on a 30-year fixed.
Obviously they don’t want to lose that low, low rate, so they turn to a home equity product instead.
They would have $200,000 in home equity, though not all of it is necessarily available to tap into.
Most home equity loan lenders will limit how much you can borrow to 80% or 90% of your home’s value.
That means a maximum loan amount of $135,000 if maxed out at 90%.
But we’ll pretend you take out just $70,000, or 80% of your property’s appraised value.
Assuming the loan term is 20 years and the interest rate is 6.75%, you’d have a monthly payment of $532.25.
The loan would amortize like a traditional mortgage, with equal monthly payments until maturity.
Each payment would consist of a principal and interest amount, which would change as the loan was paid off.
You would make this payment each month alongside your first mortgage payment, but would now have an additional $70,000 in your bank account.
When we add the first mortgage payment of $1,958.43 we get a total monthly of $2,490.68, well below a potential cash out refinance monthly of $3,034.58.
Because the existing first mortgage has such a low rate, it makes sense to open a second mortgage with a slightly higher rate.
Do Home Equity Loans Have Fixed Rates?
A true home equity loan should feature a fixed interest rate. In other words, the rate shouldn’t change for the entire loan term.
To that end, a home equity loan provides safety and stability, similar to a 30-year fixed mortgage.
However, home equity loans have higher interest rates to compensate for that lack of an adjustment.
Simply put, HELOC interest rates will be lower than comparable home equity loan interest rates because they may adjust higher.
You effectively pay a premium for a locked-in interest rate on a home equity loan. How much higher depends on the lender in question and your individual loan attributes.
Home Equity Loan Rates
Similar to mortgage rates, home equity loan rates can and will vary by lender. So it’s imperative to shop around as you would a first mortgage.
Additionally, rates will be strongly dictated by the attributes of your loan. For example, a higher combined loan-to-value (CLTV) coupled with a lower credit score will equate to a higher rate.
Conversely, a borrower with excellent credit (760+ FICO) who only borrows up to 80% or less of their home’s value may qualify for a much lower rate.
Also keep in mind that interest rates will be higher on second homes and investment properties. And maximum CLTVs will likely be lower as well.
All that being said, at the moment home equity loan rates may range from as low as 5% to as high as 12% or more.
As a rule of thumb, you should expect a rate 1-2%+ higher than a comparable 30-year fixed given the increased risk of a second mortgage.
But this spread can shrink or widen depending on market conditions.
Do Home Equity Loans Require a Down Payment?
Now let’s discuss some home equity loan requirements.
While no down payment is required on a home equity loan, since you already own the property, a required amount of home equity is necessary to get approved.
After all, the home equity loan relies upon your property as collateral, and if you don’t have any equity, there’s nothing to lend against.
In other words, you need to have a certain percentage of home equity available to get a home equity loan.
Typically, this is at least 20% of your property’s appraised value to allow for an additional loan against the property.
For example, if you own a home valued at $500,000, you’ll want to have at least $100,000 available.
This would mean an existing first mortgage with a balance of $400,000 or less to allow for more borrowing capacity.
Assuming the home equity loan only allowed for a CLTV of 80%, you’d need even more equity.
For example, a $350,000 existing first mortgage that would allow you to borrow an additional $50,000 via the home equity loan.
Do Home Equity Loans Require an Appraisal?
While it will depend on the company, an appraisal isn’t always required for a home equity loan.
The same is even true of first mortgages these days thanks to advancements in technology.
This may save you some money and make the home equity loan process significantly faster.
However, the bank or lender will still need to determine the value of the property to ensure it is a sound lending decision.
Whether you pay for an appraisal, or are paid a visit by a human appraiser, are entirely different questions.
Either way, understand that the company offering the home equity loan will base the loan amount and APR on some kind of appraised value.
This allows them to determine a LTV or CLTV for which to base pricing adjustments, interest rates, maximum loan amount, and so on.
Do Home Equity Loans Have Closing Costs?
As with the appraisal question, it may depend on the company offering the home equity loan.
Some charge origination fees and other closing costs, while others do not charge any fees.
For example, Discover Home Loans says it doesn’t charge appraisal fees or origination fees.
However, it’s important to look at the big picture, aka the interest rate, to determine what the best deal is.
Similar to a first mortgage, closing costs may not be charged, but the interest rate could be higher as a result.
You would then need to weigh the upfront cost versus monthly interest expense to determine what’s the better deal.
Also note that some lenders may ask that you reimburse them for any waived closing costs if you pay off your home equity loan within 36 months.
This is sort of like a prepayment penalty, though there may be a cap and certain states are exempt.
Just something to keep in mind if you pay off your loan ahead of schedule.
Some home equity loans may have a nominal annual fee, such as $50 per year. And if your loan amount is quite large, title insurance could even be required.
Minimum Credit Score for a Home Equity Loan
Chances are you’ll need at least a 620 FICO score to get approved for a home equity loan these days.
Some lenders may even require a higher credit score, such as a 660 FICO score, in order to get approved.
Also note that your borrowing capacity may be limited by your credit score.
For example, if you have a 620 FICO score, you might only be able to borrow up to 80% of your home’s value.
Meanwhile, a borrower with a 660 FICO might have access to up to 90% of their home’s value.
Additionally, the interest rate will also be dictated by your credit score.
Like a first mortgage, the higher your score, the lower the interest rate. And vice versa.
Do Home Equity Loans Affect Your Credit?
Yes, like a first mortgage, the home equity loan will appear on your credit report.
This includes when the loan was taken out, the outstanding loan balance, and the monthly payment.
Your payment history on the loan will also be tracked over time, which can help or hurt you.
Obviously, if you miss a payment (generally by more than 30 days) it can negatively impact your credit score.
Because it’s a home loan, the impact can be quite severe.
Conversely, if you exhibit a lengthy history of on-time payments, it can bolster your credit scores over time.
How to Get a Home Equity Loan
Similar to a mortgage, many banks and independent mortgage lenders offer home equity loans.
However, they aren’t as readily available as first mortgages, so you’ll need to dig a little deeper.
Simply put, just about all mortgage companies offer 30-year fixed mortgages, but only a handful offer home equity loans.
Chase and Wells Fargo, two of the biggest mortgage lenders out there, don’t offer them at the moment.
That could change as they become more popular, but chances are they’ll be a bit harder to come by.
Additionally, because the terms of home equity loans can vary quite a bit, it’s important to speak to several different companies during your search.
For example, some lenders may only offer home equity loans with loan terms as long as 20 years, or with a minimum credit score of 660. Or their loan amounts might be too small for your needs.
The Rocket Mortgage home equity loan recently launched, but requires a median qualifying FICO score of 680 or higher.
Others come with unique options. The PNC home equity loan allows borrowers to switch between a fixed and variable rate. In that sense, it works as a home equity loan and a HELOC in one loan.
Because this type of product can be a lot more diverse than a standard 30-year fixed, shopping around is probably a good idea.
Rates can also range quite a bit from lender to lender, so put in the time to speak with a local credit union, bank, online lenders, and even mortgage brokers.
Home Equity Loan Advantages
- Fixed interest rate
- Flexible loan terms (5 – 20 years)
- Can borrow large amounts
- Little or no closing costs
- Fast approvals and fundings
- Potential tax write-off
- Doesn’t disrupt your first mortgage (e.g. a low rate)
Home Equity Loan Disadvantages
- Entire loan amount must be borrowed upfront
- You pay interest on the full lump sum
- No additional draws permitted
- Interest rates higher than HELOCs and first mortgages
- Have to manage multiple loans
- May have annual fee
- Potential early closure fees
Are Home Equity Loans a Good Idea?
As seen in my example above, a home equity loan could be a great idea versus a cash out refinance.
But that assumes you need additional cash and your existing first mortgage features a super low interest rate that is fixed.
This might not always be the case, and it will also depend on the rate you receive on the home equity loan.
Additionally, there might be other options to consider instead of a HEL, such as a HELOC or even a 0% APR credit card.
In the past, I’ve made the argument that a credit card could be used to pay for home renovations.
At the end of the day, a home equity loan is still a loan, and likely an additional loan taken out on top of whatever you’re already paying.
So you need to consider if you really need more cash and if tapping your home equity is the way to go.
Read more: Cash Out vs. HELOC vs. Home Equity Loan