A home equity loan acts as a second mortgage, allowing you to borrow against the equity you’ve built in your home—the difference between its market value and your outstanding mortgage balance. This type of loan is attractive because it typically offers lower interest rates than other consumer loans, as your home serves as collateral. However, this also means that defaulting on the loan could put your home at risk of foreclosure.
How Does a Home Equity Loan Work?
Home equity loans provide a lump sum of cash that you repay in fixed installments over a predetermined period, usually ranging from 10 to 30 years. They are typically fixed-rate loans, meaning your interest rate and monthly payments remain constant throughout the loan term, which simplifies budgeting.
While you might qualify for a substantial loan amount, it’s prudent to borrow only what you need. For example, if you qualify for $100,000 but your kitchen renovation costs $40,000, limiting your loan to $40,000 will result in smaller, more manageable payments.
You can choose a loan term that aligns with your financial goals. A shorter term (e.g., 10 years) means quicker payoff but higher monthly payments, while a longer term (e.g., 30 years) offers lower payments but extends the repayment period.
Pros and Cons of Home Equity Loans
Before committing to a home equity loan, weigh its advantages and disadvantages against your personal financial situation.
Home Equity Loan Pros:
- Easier to qualify for: Generally, home equity loans are less risky for lenders due to the collateral, making them potentially easier to obtain than unsecured personal loans, even with a lower credit score.
- Fixed and lower interest rates: Rates are typically fixed, providing predictability, and are often lower than those for credit cards or personal loans.
- Longer loan terms: Repayment periods are often more extended compared to other consumer loans, leading to lower monthly payments.
- No restrictions on fund usage: You have the flexibility to use the lump sum for various purposes.
Home Equity Loan Cons:
- Second mortgage: You’ll have an additional monthly payment on top of your primary mortgage.
- Foreclosure risk: Defaulting on the loan can lead to foreclosure, as your home is the collateral.
- Full balance due upon sale: If you sell your home, the entire outstanding balance of the home equity loan, in addition to your primary mortgage, must be paid off.
- Closing costs: You will typically incur closing costs, similar to a first mortgage.
How to Get a Home Equity Loan
To qualify for a home equity loan, lenders will assess your home equity, debt-to-income (DTI) ratio, and credit score. A strong showing in one area can sometimes compensate for a weaker area.
- Determine Your Equity with a Home Appraisal:
A home appraisal is crucial for lenders to ascertain your home’s current market value and, consequently, how much equity you have and how much you can borrow. Lenders determine your maximum loan amount based on a loan-to-value (LTV) ratio, which is the percentage of your home’s appraised value that they are willing to lend, minus your existing mortgage balance.
For example, if your home is appraised at $400,000 and your remaining mortgage balance is $100,000, and a lender allows you to borrow up to 90% LTV (including your primary mortgage):
- Maximum combined loan amount: $400,000 * 0.90 = $360,000
- Potential home equity loan amount: $360,000 – $100,000 (primary mortgage) = $260,000
Houston Specific: The average cost for a home appraisal for a typical 2,000-square-foot single-family home in Houston is around $425, though prices can vary based on property size, features, and appraiser demand.
- Calculate Your DTI Ratio:
Your debt-to-income (DTI) ratio is a key indicator for lenders, showing how much of your gross monthly income goes towards debt payments. Most lenders prefer a DTI ratio of 43% or less to qualify for a home equity loan. Some may accept higher DTIs based on other strong factors like excellent credit, while others might require lower.
To calculate your DTI:
- Add up all your monthly debt payments (primary mortgage, student loans, car loans, minimum credit card payments, alimony, child support, etc.).
- Divide this sum by your gross monthly income (income before taxes and deductions).
- Multiply the result by 100 to get the percentage.
Example: If your total monthly debt is $1,500 ($950 mortgage + $300 car loan + $250 credit card debt), and your gross monthly income is $5,000, your DTI is: ($1,500 / $5,000) * 100 = 30%. This DTI would generally qualify you for a home equity loan.
Houston Specific: Many lenders in Houston, like Central Bank of Houston, generally require a DTI ratio of less than 43% for home equity loans. SoFi’s recommendations for best rates suggest a DTI below 36%.
- Check Your Credit Score:
Your credit score significantly impacts your eligibility and the interest rate you receive. While the minimum credit score for a home equity loan is generally around 620, many lenders prefer scores closer to 680 or even 700+ for the most favorable terms.
For instance, Rocket Mortgage offers varying LTVs based on credit score:
- 680 credit score: Up to 80% LTV (combined with primary mortgage).
- 700+ credit score: Up to 85% LTV.
- 740+ credit score: Up to 90% LTV.
Higher credit scores indicate lower risk to lenders, often leading to lower interest rates and potentially access to more of your home’s equity.
Can You Get a Home Equity Loan with Bad Credit?
While a low credit score can make borrowing challenging, it’s often easier to qualify for a home equity loan with bad credit than an unsecured personal loan. Because your home secures the loan, lenders face less risk. If you have substantial home equity and a low DTI, your chances of approval are higher despite a lower credit score, though you should expect a higher interest rate.
Alternatives to Home Equity Loans
It’s important to understand alternatives to home equity loans to determine the best fit for your needs:
- Cash-Out Refinance:
This option replaces your existing primary mortgage with a new, larger loan based on your home’s current value. You receive the difference in cash and then have a single, new mortgage payment. A key difference from a home equity loan is that a cash-out refinance typically results in a lower interest rate on the borrowed funds because it’s a first lien, meaning the lender is paid first in case of default. However, it also means your entire primary mortgage is refinanced, which might not be ideal if current interest rates are higher than your existing mortgage rate.
Texas Specific: Cash-out refinances are subject to similar strict Texas homestead laws as home equity loans, including the 80% LTV cap and other constitutional protections.
- Home Equity Line of Credit (HELOC):
Like a home equity loan, a HELOC is a second mortgage. However, instead of a lump sum, it functions more like a credit card, providing a revolving line of credit you can draw from as needed, up to a set limit. You only pay interest on the amount you’ve borrowed. HELOCs typically have variable interest rates, meaning your rate and monthly payments can fluctuate with market changes. Some lenders do offer fixed-rate options for a portion or all of the HELOC balance.
When Is a Home Equity Loan the Right Choice?
A home equity loan is often a good fit in specific scenarios:
- Immediate large sum needed: If you require a significant amount of money upfront for a specific, one-time expense (e.g., a major home renovation) and want a lower, fixed interest rate compared to credit cards or personal loans.
- Fixed budget: When you have a clear understanding of the full cost of your project and prefer predictable monthly payments that won’t change due to interest rate fluctuations.
- Consolidating high-interest debt: Using a home equity loan to pay off other debts with higher, variable interest rates can save you money and simplify your finances, as your new interest rate will be fixed.
How to Choose the Best Home Equity Loan
To find the most favorable terms and interest rates, compare offers from several lenders. Request a Loan Estimate form from each. This document will detail the loan terms, interest rate, and itemized closing costs and fees. Carefully review each estimate to ensure you understand all the details before making a decision.
The Bottom Line
A home equity loan can be an excellent financial tool if you have built substantial equity in your home, possess a strong credit score, and maintain a low DTI ratio. Its fixed interest rate ensures stable monthly payments, making budgeting straightforward. However, if managing two separate mortgages seems daunting, a cash-out refinance might be a more suitable option, as it consolidates your debt into a single payment, potentially at a lower interest rate, though it involves refinancing your entire primary mortgage.
Consider consulting with a home loan expert to evaluate a “blended rate” calculation, which helps determine whether a cash-out refinance or a home equity loan makes the most financial sense for your unique situation.