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How a Home Equity Loan Works
A home equity loan is a second mortgage taken out on a property that uses the existing equity in the property as collateral for the loan. Borrowers use home equity loans because they enable borrowers to take cash out of their properties without refinancing their first mortgages which can be costly, time-consuming and cost thousands of dollars more in total interest expense over the life of the new mortgage.
The home equity loan is subordinate, or junior, to the first mortgage on the property. In the event of a default or foreclosure, the holder of the first mortgage is paid off first before the holder of the second mortgage or home equity loan. You typically do not need to get approval from your first mortgage lender to put in place a home equity loan but the home equity loan lender reviews the first mortgage note to make sure that there is no acceleration clause that makes the first mortgage payable in full if the borrower puts a second mortgage in place.
Borrowers can use the proceeds from a home equity loan for numerous purposes including home remodeling or renovation, paying off high interest rate credit card debt or buying a second home or investment property. In fact, lenders usually do not place restrictions on how you spend home equity loan funds.
The interest rate on a home equity loan is typically 1.0% to 2.5% higher than the current market rate for a first mortgage, depending on the term of the loan. The longer the loan term, the higher the interest rate. Additionally, the interest rate for loans with a combined loan-to-value (CLTV) ratio above 80% can be 0.5% - 2.0% higher than the rate on a loan with a CLTV ratio below 80%, depending on the term of the loan. The interest rate on loans for non-owner occupied properties can be 3.0% - 4.0% higher than the rate on owner occupied properties and the lender may also limit the loan term to less than twelve years.
For a home equity loan, lenders typically charge a processing fee and and the borrower is also required to pay third party closing costs such as the appraisal fee. In some cases the lender will rebate certain closing costs so be sure to ask lenders about potential discounts and rebates when you shop for a home equity loan.
The Interest rate and fees for home equity loans vary by lender and market conditions. Loans are provided by traditional lenders such as banks, mortgage banks, mortgage brokers and credit union with credit unions offering especially competitive terms. We recommend that you contact multiple lenders in the table below to find the home equity loan with the lowest interest rate and fees.
A home equity loan is usually structured as a fixed rate loan, with the interest rate and required monthly payment staying constant over the term of the loan. Lenders offer home equity loans with terms of 5, 10, 12, 15 or 20 years with 15 years being the most common term. Although it is somewhat unusual, some lenders also offer home equity loans that are structured similar to adjustable rate mortgages, so the interest rate and monthly payment are subject to change, and potentially increase, over the life of the loan. If you think interest rates are going to increase in the future it is a good idea to obtain a fixed rate loan so that you remove the risk that your monthly payment goes up in the future.
In order to obtain a home equity loan, the borrower must have sufficient equity in the property to support the combined loan-to-value (CLTV) ratio of the first mortgage plus the home equity loan. CLTV ratio equals the total of all the mortgages on a property divided by the estimated value of the property as determined by the appraisal report.
Lenders typically permit a maximum CLTV ratio of 80%, which is based on the outstanding principal balance of the first mortgage plus the amount of the home equity loan. For example, for a property that is valued at $200,000 if the principal balance on the borrower’s first mortgage is $100,000 and the borrower takes out a $60,000 home equity loan, the CLTV ratio is 80% (($100,000 (first mortgage balance) + $60,000 (home equity loan)) / $200,000 (property value) = 80% combined loan-to-value ratio).
While most traditional lenders apply the 80% CLTV ratio limit to home equity loans some banks and credit unions offer more aggressive terms including ratios up to 90%. Please note that credit unions have membership eligibility requirements so not all borrowers. Additionally, the interest rate for a home loan with a CLTV ratio greater than 80% is typically higher than a loan with a lower ratio and the lender may limit the amount of the loan.
The CLTV ratio limit may also vary by property type. Some lenders apply a 70% ratio limit for condos and a 70% - 80% limit for non-owner occupied properties (up to four units). Please note that many lenders do not offer home equity loans on non-owner occupied properties and the lenders that do typically charge a higher interest rate and limit the term of the loan.
Because CLTV ratio is such an important factor in determining how much equity you have in your home and what size loan you can obtain it is important that you understand the estimated value of your property before you apply for a home equity loan. You can use web sites like Realtor.com, Trulia and Zillow to review an approximate value of your property and lenders may also use proprietary valuation tools.
The property value estimates provided by these sites are unofficial but can be helpful in assessing if you have sufficient equity to apply for a home equity loan. After reviewing these sites, consult your lender to determine if it makes sense to incur the time and expense required to apply for the loan. When you apply for a home equity loan, the lender orders an appraisal report from a certified appraiser to determine the actual fair market property value used to calculate the CLTV ratio. If the property appraises the same as or above the estimate property value, you are in a great position to qualify for the loan. If the property appraises for lower than the expected value, you may qualify for a lower loan amount or you may not be approved.
In order to qualify for a home equity loan, the borrower must meet the lender’s qualification requirements. Home equity loan requirements are similar to the qualification guidelines for a mortgage and focus on a borrower’s credit score and debt-to-income ratio. Debt-to-income ratio represents the maximum acceptable percentage of a borrower's monthly gross income that can be spent on total monthly housing expense, which includes your mortgage payment, home equity loan payment, property taxes and homeowners insurance plus other monthly debt payments for car loans, credit cards, student loans and spousal support. Depending on the lender and CLTV ratio, lender qualification guidelines typically allow a maximum debt-to-income ratio of 55%. Lenders may allow higher debt-to-income ratios if the CLTV ratio is less than 65%.
Lenders also review your credit report and employment status when you apply for a home equity loan. Significant changes in your personal or financial profile, such as if your credit score declined or you changed jobs, may impact your ability to qualify, even if you are current on your mortgage or never missed a payment. Applicants also must meet the minimum credit score required by the lender.
Use the FREEandCLEAR Lender Directory to find top-rated lenders that offer home equity loans.
The interest on home equity loans is tax deductible as long as the loan is used to buy, build or substantially improve the property that secures the loan. Additionally, the interest is tax deductible as long as the total amount of loans secured by the property does not exceed the value of the property and the total amount of the loans, including the first mortgage, does not exceed $750,000 (in most cases).
For example, if you take out a home equity loan on your primary residence to pay for home renovations or remodeling, then the interest expense on the loan is tax deductible. If you take out a home equity loan and do not use the proceeds to buy, build or substantially improve your home, such to pay for a vacation, college tuition or to payoff credit card debt, then the interest expense on the loan is not tax deductible.
Please note that the interest expense on a home equity loan for a second or vacation home is tax deductible as long as the loan is secured by the second or vacation home and the the total amount of the loans on your primary, second or vacation homes does not exceed $750,000. If you use a HELOC on your primary residence to buy a vacation home, the interest expense on the home equity loan is not tax deductible. We advise you to consult a tax professional to understand how the home equity loan interest tax deduction applies to you.
Related FREEandCLEAR Resources
- Home Equity Loan Pros and Cons
- Comparing a Home Equity Loan and Line of Credit
- Comparing Refinancing to a Home Equity Loan
Sources
“What is a home equity loan?” CFPB. Consumer Financial Protection Bureau, September 25 2017. Web.
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