Home equity loans & lines of credit: 7 common questions answered

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If you’ve been in your home for a while and the value of your property has held steady or increased, you likely have equity in it. In the simplest terms, equity is the amount your home is worth minus the amount you owe on the mortgage. In one very specific case (which we’ll outline below) you may want to consider accessing some of that equity via a home equity loan or home equity line of credit (HELOC).

What is a home equity loan?

A home equity loan is a loan that a lender gives you based on the amount of equity you have in your home. The more equity you have, the more you are able to borrow. With a home equity loan, the lender loans you a lump sum of money at a particular interest rate, which is usually fixed. You then have a particular amount of time, usually from 5 to 15 years, to pay that loan off, typically by making monthly payments just like you do with your mortgage.

What is a home equity line of credit (HELOC)?

With a home equity line of credit (HELOC), instead of giving you a lump sum of money, the lender extends you a certain amount of credit that you are able to access via checks, a debit card or electronic transfers. As you draw money from the line of credit, you are responsible for paying back a portion of the amount of money you’ve borrowed each month. HELOCs typically come with a variable interest rate that is tied to the prime rate set by the Federal Reserve. This means that if the prime rate goes up, the cost of borrowing money also rises.

Who should get a home equity loan?

Money expert Clark Howard has a hard and fast rule about who should get home equity loans and HELOCs: “Use home equity lines to improve your home. That’s the ONLY reason to get one.”

You may be tempted to draw on your home’s equity to access money for a fancy vacation or to buy a new car, but that can be a recipe for disaster. Since the interest rate floats with the prime rate, you could end up paying far more for that luxury than you intended and if you can’t find the money to pay the loan back, you’re putting your home at risk.

Do I qualify for a home equity loan?

Your lender uses home equity to calculate the loan-to-value ratio, or (LTV), which is then combined with other factors to determine the amount of loan you might be eligible to receive. In order to do this, the lender takes the current loan balance and divides it by the current appraised value of the property.

Here’s an example: You currently owe $210,000 on your mortgage. Your home appraises for $400,000. Using the LTV calculation, you would divide $210,000 by $400,000, giving you 0.525. This gives you a loan-to-value ratio of 52.5%.

Now, consider the amount of money you want to borrow. For our example, assume it’s $50,000. You would add what you currently owe on the mortgage ($210,000) and the desired loan ($50,000) for a total of $260,000. Now simply divide the $260,000 by $400,000. The result: 0.65, which translates to 65%. This is your combined loan-to-value ratio (CLTV).

Most lenders want to see a CLTV of 85% or less in order to consider awarding a home equity line of credit. In our hypothetical scenario, you would definitely qualify.

But your ability to get a home equity loan is dependent upon more than just how much money you have in the house. Lenders also look at your credit score and debt-to-income ratio, just as they would if you were applying for a mortgage for the first time.

Shoot for a credit score of at least 660 before applying for a home equity loan — that’s what the folks at TD Bank want to see, according to BankRate.

How do I find the best rates on a home equity loan?

You can compare rates from national lenders at various sites on the internet, including Bankrate.com and Lendingtree.com. You may also want to check the rates at banks and credit unions in your local area, especially if you are more comfortable doing business in person. You will often find that the rates at smaller institutions compare favorably with the larger banks and lenders.

What information will I need to submit for a home equity loan?

While the application process varies slightly from lender to lender, you should plan to be prepared to share the following information as part of the application process:

  • Copy of all applicants’ drivers licenses
  • Recent pay stubs, including proof of Social Security
  • Full tax returns and W-2s for a certain number of years
  • A copy of your Warranty Deed and survey of your property, if available
  • Proof of homeowners insurance
  • A tax assessors notice and/or property tax bill
  • A copy of your mortgage statement

Your home will also need to undergo an appraisal to establish its current market value. The appraiser will be one selected by the bank and the cost of the appraisal will either be absorbed by the bank or rolled into your loan.

How long does it take to get a home equity loan?

The amount of time it takes to complete a home equity loan from the submission of the application to closing will vary with the institution and circumstances, but you should plan for it to take anywhere from 2 to 6 weeks.

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