A home equity loan is a form of consumer debt that allows you to borrow money against your home’s equity. The loan payments are added on top of your mortgage balance, which is why a home equity loan is often called a “second mortgage.”

A home equity loan allows you to access money that would otherwise remain tied up in your property and unavailable for use. Your equity is the portion of the property that you’ve paid off, in addition to any home improvements you made to the property to increase its market value. It can be a great way to fund home remodeling projects, take care of unexpected medical bills, consolidate debt, pay education costs, or get you through periods where income may be tight.

What are the possible benefits of a Home Equity Loan?

• Immediate funds
• Limitless spending options
• Fixed monthly payments/interest rates

How Does a Home Equity Loan Work?

When you take out a home equity loan, the funds are generally dispersed in a lump sum and paid back in regular, fixed installments over a predetermined amount of time.

Once the home equity loan is finalized, the lender gives you the entire borrowed amount all at once. Then, defined by the agreed-upon terms and conditions of the loan, you will be required to start making monthly payments. As with a standard mortgage, these payments will include both the principal of the home equity loan, as well as interest.

The monthly amount that you will be required to pay towards your home equity loan will depend on a range of factors, but it’s typically accepted that a shorter-term loan (such as one with a 10-year term) will demand higher monthly payments than one spread out across 15 or 30 years.

Is a Home Equity Loan Right for Me?

Although a home equity loan can help you free up funds that would otherwise be unavailable, you shouldn’t think of your equity as just another source of funds. When determining if a home equity loan is right for you, you may want to consider the following.

Home equity loans can be:

• A lifesaver when you need cash quickly to cover emergency expenses
• Extremely beneficial for use in renovating your home
• Instrumental in consolidating debt or handling other important costs

If you’ve generated enough equity in your home, have a low debt-to-income ratio and a strong credit score, a home equity loan may be worth considering. Plus, home equity loans include fixed interest rates, meaning your monthly payment will never change. This gives you the opportunity to budget accordingly.

Home Equity Loan vs. HELOC vs. Cash-Out Refinance

Research is an important step in determining what type of home loan is right for you and your financial goals. A home equity loan, HELOC and cash-out refinance allow homeowners to borrow against their home for larger purchases. As a homeowner, you will establish equity and open up cash-out options that can be used for home improvements, paying off debt, or any additional projects.

HELOC

Rather than providing a single, one-time lump sum at a fixed interest rate, a home equity line of credit (HELOC) gives you an ongoing, variable interest rate line of credit secured by your home equity. Although HELOC rates tend to be lower than rates for home equity loans, they can fluctuate significantly based on the market and other factors, making them potentially more difficult to budget for.

Cash-Out Refinance

Where a home equity loan creates a second mortgage in addition to your original mortgage, a cash-out refinance settles and replaces your original mortgage with a new loan at a higher balance. The difference between the two loans is then made available to you as cash. This means you’ll still only have one mortgage payment to make every month, but you’ll also need to cover the higher closing costs associated with taking out a new home loan.

In essence, a home equity loan, HELOC and cash-out refinance allow you to borrow against the equity in your home. However, HELOCs provide you with a predetermined amount of money and cash-out refinances replace your primary mortgage.

Frequently Asked Home Equity Loan Questions

Do I qualify for a low interest rate?

Qualifying for a low interest rate is dependent on your credit score, debt-to-income ratio and payment history. Your credit score indicates your creditworthiness and the likelihood you will repay a debt, while a debt-to-income ratio compares monthly debts and payments to pre-tax monthly income. You can calculate your individual debt-to-income ratio using the following equation:

DTI = Total Monthly Debt Payments / Gross Monthly Income

The bottom line is, borrowers with a higher credit score and a lower debt-to-income ratio have a greater chance of qualifying for a home equity loan with a low interest rate.

What will I be required to provide?

Similar to applying for a mortgage, you will be required to provide all necessary documents in order to qualify for a home equity loan. You are also responsible for all closing costs, though you may have the option to roll some costs into your loan amount.

The documentation you are required to provide include:

• E-sign loan disclosures
• Income documentation to support stated income
• W2 Wage Earners: W2s and pay stubs
• Self Employed: 2 years tax returns (business/personal or both)
• Retired: proper award letters, 1099s and/or bank statements, etc.
• Similar to when you applied for your original mortgage, you will be required to provide all of the necessary documents to prove your borrowing worthiness and you will be responsible for closing costs, though you may have the option to roll some costs into your loan amount.

Some of the documentation required may include:

• Pay stubs
• Tax returns and W-2′s and/or 1099′s
• A credit report
• Bank statements

Do I know how much I need to borrow?

If you need a specific amount right away and don’t want to risk overspending, a home equity loan can be a reliable solution that is also relatively easy to budget for — the fixed payment plan will help ensure that you know exactly how much you will owe towards the loan every month until it’s fully settled.

Will the loan help me build more equity or save money in other areas?

It’s worth noting that if you’re using a home equity loan to pay for home improvements, you may not only be further increasing the value of your home (and building more equity), but you’ll also have the opportunity to deduct the home equity loan interest from your taxes.

What if I decide to sell my property before I settle the loan?

Keep in mind that if you sell your home before fully paying off the home equity loan, the proceeds from the sale might not be enough to settle both the original mortgage and the remainder of the home equity loan. In this case, you could end up in a difficult situation, having to find another income source to settle the loan.

Is Home Equity Loan Interest Tax Deductible?

Home equity loan interest may be tax deductible, provided that your total mortgage debt is $750,000 or less, you itemize your deductions, and you apply the loan towards substantial home improvements.

Consult a tax adviser for further information regarding the deductibility of mortgage interest and charges.