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If you need money to cover life’s big expenses, tapping into the equity in your home can be a smart option. One way to do that is by getting a home equity loan. In the post below, we’ll describe what this loan is, how it works, and how to qualify for one of your own. Keep reading to learn if this financial move makes sense for you.
What is a home equity loan?
A home equity loan is often referred to as a second mortgage because that’s truly what it is. It’s a loan that lets you borrow against the value of your home. Often, this type of loan can be a way for homeowners to access large sums of money to pay for life’s big expenses. It’s not uncommon to see someone take out a home equity loan to finance home improvements, to cover medical debts, or to assist a child in paying for his or her education.
Home equity loans are often an attractive source of funding because they’re available at lower interest rates than credit cards or personal loans. However, be aware that those low interest rates come with a high amount of risk. Lenders feel comfortable offering lower rates because these loans are secured by your home, meaning that the lender can foreclose on you if you decide to stop making your payments.
How does it work?
Put simply, home equity loans work in much the same way that your first mortgage did when you initially bought your house. The money from the loan is disbursed as a lump sum, allowing you to use it as you see fit. After you receive it, you start making fixed, monthly payments to pay back the loan.
With each payment, you’ll always be paying down a portion of both the principal and the interest. Also of note, home equity loans come with fixed interest rates.
Qualifying for a home equity loan
Again, qualifying for a home equity loan is very similar to qualifying for a first mortgage. Your lender will want to see proof of employment, as well as records of your debts and assets. You should be prepared to bring the following documentation with you when you visit your lender.
- Two years of W-2’s or tax returns, if you’re self-employed.
- Your most recent pay stub with your year-to-date income listed
- Statements for all your bank accounts and assets
- Debt records for any credit cards or other loans
However, in addition to these documents, your lender will also look at one more piece of information. He or she will evaluate how much equity you have in your home. (Remember, equity is the percentage of your home that you own outright.) Here, the amount of equity you’ve built up in your home will help determine how much money you can borrow. Most lenders only allow you to borrow against up to 85% of your equity.
To find out how much you can borrow, follow this equation:
- The amount your home is worth x the percentage of home equity you’re allowed to borrow – how much you owe on your home
For example:
- Let’s say your home is worth $200,000 (according to a recent appraisal) and you’re allowed to borrow up to 85% of your home equity, but you still have a $100,000 balance on your mortgage.
- $300,000 x 0.85 = 170,000
- $170,000 – $100,000 = $70,000
- In this case, you’d be approved for a $70,000 loan.
The difference between a home equity loan and a home equity line of credit
Often, home equity loans and home equity lines of credit get confused for each other. They’re similar in that they both let you borrow against the value of your home, but they work much differently from one and other.
While a home equity loan functions like a traditional mortgage, a home equity line of credit works like a credit card. It gives you a period of time when you’re allowed to draw on the equity in your home, as needed. Home equity lines of credit also have adjustable interest rates.
If you’re not sure which of the two is right for you, talk to your current loan officer and/or a financial advisor. They can help you take a more in-depth look at your options in order to decide which one will serve you the best.