How Does A Home Equity Loan Work?

Are you exploring loan options and want to know how home equity loans work? Learn about whether this loan is right for you.

A home equity loan allows a homeowner to get a second mortgage by tapping into their home’s value, all without needing to pay off their existing mortgage. With this loan, they receive a lump sum, which they can repay in monthly installments, using the equity they’ve built up in their home as collateral.

But how does a home equity loan work in simpler terms? If your home is worth $500,000 and you owe $200,000 on your mortgage, you can borrow against the $300,000 in equity you’ve acquired, using it as collateral.

Below, we explore more details about how this type of loan works, the qualifications to get approved, and when it might make sense to get one.

Is It A Good Idea To Take Equity Out Of Your House?

Taking equity out of your house can be a smart financial move in certain situations – like funding home improvements that increase your property’s value, consolidating high-interest debt, or covering large expenses, such as education or medical bills. Since home equity loans often offer lower interest rates compared to credit cards or personal loans, this can help save on interest costs.

However, it’s crucial to consider the risks. Borrowing against your home’s equity adds to your overall debt, and if you’re unable to make the monthly payments, you risk losing your home. Additionally, tapping into your equity reduces the amount of ownership you have in your home, which could affect your financial security if housing market values drop.

Overall, the decision to take out a home equity loan is personal, and it should only be considered after weighing all the pros and cons. While a home equity loan may be fitting for certain situations, it may be the wrong approach in other circumstances.

What Disqualifies You From Getting A Home Equity Loan?

Although it looks simple, getting a home equity loan isn’t easy. Lenders consider a lot of factors before deciding if you qualify for a loan.

Here are some factors that can disqualify you from getting a home equity loan:

Having Low Home Equity

A home equity loan relies on you having paid off a portion of your mortgage. Lenders typically prefer that this amount be significant to feel confident you’ll repay the loan. If your home equity is low, your chances of qualifying for this type of loan will likely decrease.

Having A Bad Credit Score

Poor credit can impact your ability to get a home equity loan, as a low credit score signals to lenders that you may be a higher risk as a borrower and unable to afford to repay the loan.

To improve your chances, work on raising your credit score before applying – pay down existing debts and correct any errors on your credit report.

Alternatively, some lenders specialize in giving loans to individuals with bad credit. They’re another option to consider, but they may not offer the most favorable terms.

Having A High Debt-to-Income Ratio

Lenders like to assess a borrower’s income compared to their current debts when deciding on loan approvals. If you have more debts than income (a high debt-to-income (DTI) ratio), you’re less likely to qualify for a home equity loan.

To boost your chances, settle your current debts and lower your DTI ratio before applying.

Unemployment/Unstable Income

An unstable income suggests that the borrower might struggle to repay the loan, which is why lenders usually prefer applicants with a consistent and verifiable income.

Rather than applying for a home equity loan while between jobs, it’s best to wait until you have steady employment to increase your chances of approval.

Having A Certain Property Type

Certain property types are a red flag and will lower your chances of getting a home equity loan – including condos, multi-family homes, and properties on leased land.

Most of the time, individuals with these types of properties don’t have full control over the land, which can be a problem for lenders, especially if they need to foreclose.

Outstanding Issues On A Property

Some outstanding issues like pending court judgements, tax liens, or disputes with creditors can make it difficult to get approved for a home equity loan.

These issues indicate that your property may not be reliable collateral to lenders. Properties free of legal complications are preferred, as lenders want to avoid involvement in any potential legal issues.

Is It Easy To Get Approved For A Home Equity Loan?

Securing approval for a home equity loan is generally easy, provided you meet the lender’s criteria. Lenders typically require applicants to have at least 20% home equity before giving out loans. This means that even after accounting for the loan, the borrower should still have at least 20% equity on the property left over.

For example, say you have a property valued at $500,000, with $300,000 already paid off. To secure another loan using your $300,000 equity as collateral, the loan amount must be less than $300,000.

In this instance, a $350,000 loan would not be approved, as lenders require there to be remaining equity after the loan is subtracted. In this case, you could only qualify for a loan in the $250,000-$270,000 range.

Having a good credit score of around 630 and above and a DTI ratio below 43% are other things that can make getting approved for a home equity loan easier.

Do I Need An Appraisal For A Home Equity Loan?

Loans come with risks, so lenders carefully assess applicants before approving them. This includes appraising the collateral property to confirm its market value is significant.

The lender will ensure you own a valuable property with enough equity built up. Once this is confirmed, your chances of approval are much higher.

Which Is Better? HELOC vs. Home Equity Loan

A home equity loan provides a lump sum with fixed monthly payments over a set period, typically ranging from 5 to 30 years. In contrast, a home equity line of credit (HELOC) functions like a credit card, offering access to a specific credit limit that can be drawn from at any time during the term, usually 10 years. During this draw period, the borrower makes interest-only payments. After this period ends, the repayment phase begins, with payments covering both principal and interest over 10 to 20 years.

People tend to use a HELOC for emergencies that may come up over time, like home maintenance or even paying for education expenses. While this gives you easy access to cash, using your home as collateral, the monthly payments can be unpredictable.

While a HELOC allows you to withdraw in small increments to borrow what you need over a period of time, a home equity loan grants you access to the lump sum at once. The former is flexible, while the latter is more stable.

But again, deciding which is better is a personal decision and depends on your needs and financial situation.

Why Choose A+FCU For Home Equity Loans

Applying for a home equity loan with A+ Federal Credit Union is easy and straightforward. A+FCU offers competitive interest rates and flexible terms. You could even borrow up to 80% of the value of your home minus any liens, with both a home equity loan or a HELOC.

Need help deciding which option to go for? There’s a dedicated mortgage lending team to answer all your questions and help you choose which option is best for you. Ready to get a loan with no stress? Click here and become an A+FCU member.

Membership required. LTV = Loan to Value. Programs, rates, terms, and conditions are subject to change without notice. Normal lending criteria apply. All loans subject to credit approval. Property must be located in Texas and primary owner-occupied single-family residence. $495 processing fee for loans less than $40,000. $795 processing fee for loans $40,000 and above. HELOC maximum loan amount of $250,000. NMLS #405608.