How a Home Equity Loan Works
- Home Equity Loan Overview
- Key Home Equity Loan Terms
- Home Equity Loan Interest Rates and Fees
- Home Equity Loan Combined Loan-to-Value Ratio (CLTV) Requirement
- Home Equity Loan Borrower Qualification Requirements
- Related FREEandCLEAR Resources
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 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. Borrowers use home equity loans because they enable borrowers to take equity 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 will want to review the first mortgage note to make sure that there is no acceleration clause in the note that makes the first mortgage payable in full if the borrower puts a second mortgage in place.
From a tax standpoint, interest expense on a home equity loan up to $100,000 (or $50,000 if married filing separately) is typically tax deductible. If you use the proceeds from the home equity loan to pay for past (within the prior 24 months) or current substantial improvements to your property then the home equity loan may qualify as home acquisition debt and the interest expense on loan amounts above $100,000 may be tax deductible. We advise you to consult a tax specialist to determine the tax treatment for the interest expense on a home equity loan.
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 home equity loan so that you remove the risk that your monthly mortgage payment goes up in the future.
The interest rate on a home equity loan is typically 1.0% to 2.5% higher than the current market interest 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 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 on home equity loans vary by lender and market conditions. Home equity loans are provided by traditional lenders such as banks, mortgage banks, mortgage brokers and credit union with credit unions offering especially competitive terms. FREEandCLEAR recommends that you contact at least four lenders when shopping for your home equity loan to find the loan with the lowest interest rate and fees. Click on lenders in the table below or INTEREST RATES to compare lenders.
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 CLTV ratios up to 90%. Please note that credit unions have membership eligibility requirements that may not apply to 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 CLTV 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% CLTV 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 what size home equity 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 the estimated value of your property and lenders may also have proprietary property valuation tools. The property value estimates provided by these sites are unofficial approximations but can be helpful in assessing if you have sufficient equity in your home 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 will order an appraisal report from a certified appraiser to determine the actual property value used to calculate the CLTV ratio.
In order to qualify for a home equity loan, the borrower must meet the lender’s qualification requirements. Lender qualification guidelines for a home equity loan are similar to the qualification guidelines for a mortgage and focus on a borrower’s front end and back end debt-to-income ratios. The front end 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 (MHE) which includes your mortgage payment, home equity loan payment, property taxes, insurance and other applicable expenses such as homeowners association fees, private mortgage insurance (PMI) and FHA mortgage insurance premium (MIP).
The back end 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 plus other monthly debts such as auto, credit card, student loans and spousal support. Lenders typically focus on the back end debt-to-income ratio to determine a borrower’s ability to qualify for a home equity loan. Depending on the lender and CLTV ratio, lender qualification guidelines typically allow a maximum back end debt-to-income ratio of 55%. Lenders may allow higher back end debt-to-income ratios at lower CLTV ratios (CLTV of less than 65%).