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How to Apply for a Home Equity Loan: A Step-by-Step Guide

<p>SDI Productions / Getty Images</p>

SDI Productions / Getty Images

Reviewed by Thomas BrockReviewed by Thomas Brock

Applying for a home equity loan is similar to applying for many types of loans. You’ll need to provide the documents requested by your lender, and then your lender will determine whether you meet its criteria. Learn more about how you can apply for a home equity loan and how to find the right home equity loan to meet your needs.

Key Takeaways

  • The application process for a home equity loan requires documentation to verify your income and assets.
  • A home equity loan, or a second mortgage, lets you borrow funds using your home as collateral.
  • Your credit history, debt-to-income ratio, and the amount of home equity you have play a role in determining if you will be approved for a home equity loan.
  • With better credit, you can qualify for better interest rates.
  • When considering a home equity loan, compare lenders and look at alternatives to determine if it’s best for you.

What Is a Home Equity Loan?

A home equity loan lets you borrow from your equity, which is the value of your home that you’ve already paid for. It functions much like other types of installment loans in that if you’re approved by the lender, you receive the entirety of the loan as a single lump sum.

You can then spend the money however you see fit, such as for debt consolidation, paying emergency bills, or a home remodeling project. The loan is repaid through a series of scheduled payments over the course of the loan’s term, which typically lasts from five to 30 years.

Home equity loans have a fixed interest rate that’s generally lower than other kinds of loans since it uses the home as collateral and reduces the risk for the lender. Home equity loans are also commonly called second mortgages.

How a Home Equity Loan Works

If you’re considering a home equity loan, here are the main loan features to evaluate.

  • Fixed rates: Home equity loans have a fixed interest rate so your payment will remain the same for the life of the loan. 
  • How rates are determined: Lenders have a rate range they offer borrowers depending on market conditions and a number of factors. Those who have a good credit score and an overall stronger borrower profile will qualify for the lower end of the rate range.
  • Terms: Home equity loan term length varies from 5 to 30 years. Longer terms will mean a lower monthly payment, but a higher cost over the life of the loan.

How Much Home Equity Can You Borrow?

To figure out how much home equity you can borrow, you’ll need to get out the calculator to crunch some numbers. 

  1. Start with your home value. You can use online tools to estimate your home value, speak with a real estate agent who can help you figure out the value, or get a home appraisal (which you will ultimately need as part of your home equity loan application).
  2. Find out the percentage of home value you are allowed to borrow. This could vary slightly by lender, but generally, you may be able to borrow up to 85% of your equity. So if your home value is $400,000 and you can borrow up to 85%, then you could borrow $340,000. 
  3. Subtract the amount you currently owe on your mortgage from the maximum you can borrow. Continuing with the same example above, if you still owe $200,000, that means you can borrow up to $140,000 ($340,000 – $200,000 = $140,000).

Advantages and Disadvantages of a Home Equity Loan

Pros

  • Lower interest rates

  • Fixed interest

  • Possible tax advantage

Cons

  • Closing costs

  • Your home is collateral

  • Lengthy application process

Pros Explained

  • Lower interest rate: Home equity loans generally have lower interest rates than other types of loans, such as personal loans.
  • Fixed payments: You’ll have a fixed interest rate, so you won’t have to worry about your cost going up during the loan. 
  • Possible tax advantage: Depending on your tax situation, you may be able to deduct the interest you pay on your home equity loan.

Cons Explained

  • Closing costs: Home equity loans have closing costs just like mortgages. These are usually rolled into the loan amount, which lowers the amount of funding you get. 
  • Your home is collateral: This can be risky if you have difficulty with payments later on. If you stop paying the loan, the bank can foreclose on your home.
  • Lengthy application process: The application process for a home equity loan can take up to a few months to complete. 

Home Equity Loan Requirements 

Getting a home equity loan does require that you meet certain borrower requirements.  

At Least 20% Equity in Your Home

Lenders won’t allow you to borrow the full amount of your equity. Instead, they will generally limit you to 80% of it, with some lenders allowing up to 85%. So, if you’ve built up $100,000 in equity, you might be able to borrow as much as $80,000 to $85,000 if you meet all the other requirements. Note, too, that home equity loans typically have closing costs of several thousand dollars, so you will walk away with less than the amount you’ve borrowed.

Credit Score at Least in the Mid-600s

Prospective lenders will also expect you to have a solid credit score, which is used as an indicator of your creditworthiness. Though lenders differ, most require a credit score of at least the mid-600s, but a score above 700 will provide you with more options.

The higher your credit score, the better your chances of getting the best rates. (The highest possible credit score is 850, but anything over 670 is considered good.) 

The lender will also review your credit report for additional information regarding your credit history, including the types of credit you have, how much you owe, how long accounts have been open, and whether you have any late payments on your file.

Not Too Much Existing Debt

The last major factor is your debt-to-income (DTI) ratio, which measures how much of your monthly income is required to cover outstanding debts. Expect to provide proof of income in the form of pay stubs, W-2 forms, or other relevant documents. 

In most cases, lenders will want to see a DTI no higher than 36%, although some may go as high as 43%. All of your monthly borrowing expenses, including your existing mortgage payment, any student loan debt, credit card bills, and other debt, is added up and then divided by your monthly income to arrive at this number.

How to Apply for a Home Equity Loan

  1. Determine how much you want to borrow. Think carefully about how much you want your loan to be, keeping in mind that you will be reducing the equity in your home and increasing your monthly debt obligation. You’ll also be paying closing costs, which will reduce the lump sum amount you get. Your goal should be to borrow just enough rather than taking more than you need.
  2. Assess your credit status. Because your credit score will help determine if you will qualify for the home equity loan, you should look at your credit reports and your credit score to see if you need to make improvements. If you do not have at least a mid-600 score or you want to qualify for the best rates, try to make score improvements in the months before you apply.
  3. Shop home equity loan quotes. It’s always a good idea to compare home equity lenders and interest rates to be sure you are getting the best deal possible, especially when you’re borrowing a significant amount of money. You can start by contacting banks or credit unions you already have a relationship with, explore home equity loans online, or work with a mortgage broker. Once you have lender quotes, compare the interest rates, loan term options, fees, and other pertinent loan details.
  4. Apply for your loan of choice. Once you decide which home equity lender is best, you can begin the application process. This can be done online, by phone, or in person, depending on the lender. You’ll need to provide your contact information; answer questions about your loan needs; provide documentation regarding your income, assets, and debts; and give permission for a credit check.
  5. Go through the underwriting process. The lender will review your application and an underwriting team will work to verify your information and reach out with any additional questions. During this period, you may be asked to set up a home appraisal to confirm the value of the home. This process can take a few weeks. If everything goes through, you will be approved and a closing date will be set.
  6. Receive your loan. The final step is to close the loan and sign documents promising to repay. Be sure to look over the loan disclosure carefully to make sure you understand your obligations and to confirm all the numbers. Once you complete closing, the funds will be disbursed into your account of choice.

Alternatives to Home Equity Loans

There could be a number of reasons for not qualifying for a home equity loan, but the most common are not having enough equity, not meeting the credit or DTI minimum requirements, or not having a reliable source of income. If you don’t meet the lender’s qualifications, or just decide it’s not the right product for you, there are some other borrowing options to consider. 

  • HELOC: A home equity line of credit is another way to tap into your home equity, but instead of a lump sum, you’ll get a revolving credit line. This means you can borrow a portion of the current credit limit, spend the funds, repay those funds with interest, and then take money out again within a set term. 
  • Personal loan: These loans tend to have higher interest rates than a home equity loan. Because they are unsecured loans, you won’t put your home or other collateral at risk.
  • Cash-out refinance: If you wish to refinance your existing mortgage, you could explore a cash-out refinance, which adds an extra amount onto a new mortgage loan that will be paid to you as a lump sum. This option also involves a lengthy application process and closing costs. If you are able to lower your interest rate or improve your mortgage terms in some way, however, it could be a good option.
  • 0% APR credit card: If you need to make a large purchase (but not too large) that you think you can pay off within a year or two, a credit card with a 0% APR introductory offer can give you some time to make payments interest-free. Some credit cards offer up to 18 months. The downside is that if you do not complete the payoff, then the interest rate on your remaining balance will be significantly higher than a home equity loan. 
  • Certificate of deposit (CD) loan: If you have money in a CD, you can look into a loan that lets you use the CD as collateral. This is a type of secured loan.
  • Family loan: Borrowing from family or friends is another option to consider, but you’ll want to try to formalize the loan in some way so everyone understands the terms. The risk is that you may put your relationship in jeopardy should you have trouble paying back the loan.

Can I Borrow 100% of My Home Equity?

Most lenders will want you to have at least 15% to 20% equity in your home both before and after the home equity loan. So, for example, if your home is currently worth $300,000 and you still owe $270,000 on your mortgage, your equity is $30,000, or 10%. In that case, you most likely wouldn’t qualify for a home equity loan.

What’s the Best Use for a Home Equity Loan?

Home equity loans can generally be used for any reason, but the most common ones are: to pay for a home improvement project or repair; to consolidate high-interest debt; or to pay for a large expense like medical bills or a wedding. It’s up to you to weigh whether or not your reason for the loan is a worthy one, but keep in mind that you’re borrowing against your home so you don’t want to make that decision lightly.

How Much Can I Borrow With a Home Equity Loan?

You can typically borrow up to 80% to 85% of your home equity. In other words, if your home is valued at $500,000, 80% equity is $400,000. From that, you’ll have to subtract what you owe on your current mortgage. If you owe $300,000 in this scenario, you could borrow up to $100,000.

How Long Does It Take to Get a Home Equity Loan?

A home equity loan can take anywhere from a few weeks to a few months to get. The application process can take some time since it involves sharing documentation, underwriting, an appraisal, and a closing.

Can I Get a Home Equity Loan With Bad Credit?

Though lenders differ, most will want to see a credit score in the mid-600s or higher before even considering your application. If you are able to find a home equity lender that allows bad credit, it will likely have a higher APR and fees and less desirable terms.

The Bottom Line

Applying for a home equity loan is a straightforward process, but you’ll want to take steps to ensure you find the right loan to meet your needs. Before you apply, fully understand what you can afford to repay and compare rates and terms from various lenders to get the best loan for you.

Read the original article on Investopedia.

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