What is a home equity loan? How does it work?

A few key points to keep in mind:

• Collateral: Your home serves as collateral for the loan, meaning that if you fail to repay it, the lender could potentially foreclose on your home.
• Fixed interest rate: Home equity loans typically come with fixed interest rates, which means your monthly payments remain consistent throughout the loan term. A home equity line of credit (HELOC) is another way to borrow money from your home equity but works more like a revolving line of credit and most often comes with variable rates.
• Uses: Home equity loans can be used for a variety of purposes like home improvements, debt consolidation, education expenses, or even a dream vacation.

Before diving into a home equity loan, you may want to understand the risks involved, assess your financial situation, and consider your borrowing needs.

How much home equity do you have?

Simply put, your home equity can be calculated by subtracting all debts secured by your home from your home’s current fair market value.

• For example, if your home is worth $400,000 and your current mortgage is $240,000, then you have $160,000 of equity in your home.

Your borrowing ability depends on your combined loan-to-value (CLTV) ratio. CLTV is your new loan amount plus your mortgage balance, divided by your home value.

• In the example above, you could potentially borrow up to $120,000 of your home equity with a lender that approves borrowing up to a 90% CLTV limit. This is because a new loan amount of $120,000 plus a $240,000 existing mortgage balance divided by the $400,000 home value is equal to a 90% CLTV ratio.

CLTV borrowing limits may vary by lender, and your borrowing ability will also depend on other factors for eligibility such as your credit score and debt-to-income (DTI) ratio.

READ MORE: What is a loan-to-value ratio and how is it calculated?

What are the requirements to qualify for a home loan?

Eligibility requirements for a home equity loan will vary by lender. As an example, Discover® Home Loans looks at several factors to determine if you are a qualified borrow, including:

• Equity in your home: You will need to have enough equity available in your home to borrow from. This means that a loan amount between the borrowing limits of $35,000 to $300,000 added to all other loans secured by your property must equal below 90% CLTV for you to take out a home equity loan.
• Qualifying credit score: You will need to meet your lender's minimum credit score requirements. For example, Discover Home Loans requires a credit score of 680 or above to qualify for a home equity loan. The higher your credit score is, the more likely you will be approved for lower interest rates on your loan.
• Debt-to-income (DTI) ratio below 43%: When you’re looking to borrow money, it’s typically a good idea to make sure to have an idea of your debt-to-income ratio — the amount of your existing debt payments divided by your income. In general, mortgage lenders tend to make the best rates available to borrowers with a DTI ratio under 43%.
• Documented income: Whether you’re earning a salary or hourly wages, self-employed, or work as a freelancer, you will need to provide documentation that indicates you make enough income to successfully pay back the loan.
• Credit history: All lenders will want to see that you have a history of making payments on time. They may request copies of your credit report to assess this, so try to review your report to catch and resolve any inconsistencies or errors before applying for a loan.

In addition to this details, an appraisal report will be ordered by a lender to assess the value of your home. While this may be a cost charged back to you as the borrower, Discover Home Loans  charges no appraisal fees, origination fees, or costs at closing.

READ MORE: How to qualify for a home equity loan

Pros of home equity loans

A home equity loan can be a useful financial tool for homeowners who want to tap into the equity in their property to fund large expenses. This is because they have features such as:

• Lower interest rates: Home equity loans typically have lower interest rates compared to other forms of credit, such as personal loans or credit cards. This is because the loan is secured using your home as collateral while other financing options are unsecured and not backed by any form of collateral.
• Large loan amounts: Home equity loans may provide access to significant amounts of money, depending on the value of your home and the amount of equity you have built up.
• Flexible use of funds: You can use the funds from a home equity loan for a variety of purposes, such as home improvements, debt consolidation, or paying for major expenses like college tuition or medical bills.
• Tax-deductible interest: The interest paid on a home equity loan may be tax-deductible if the funds are used to buy, build, or substantially improve the home that secures the loan. Be sure to consult with a tax professional to understand options for your situation.

It’s important to speak with a personal banker who can evaluate your set of circumstances and guide you through the process of selecting a home equity loan.

Cons of home equity loans

There are some potential downsides to borrowing money using a home equity loan that you should be aware of, including:

• Risk of foreclosure: Because your home serves as collateral for the loan, failing to make payments on a home equity loan can result in the loss of your property.
• Closing costs and fees: Home equity loans can come with closing costs and fees, which can add to the overall cost of the loan. However, some lenders offer to cover these fees, so comparing your options before deciding may help you decide what works best for you.
• Reduced home equity: Taking out a home equity loan reduces the amount of equity you have in your home, which might limit your financial flexibility and borrowing power in the future.
• Possible impact on credit score: Applying for a home equity loan will result in a hard credit inquiry, which may temporarily lower your credit score. Additionally, having a large outstanding debt may impact your credit utilization ratio, which is a significant factor in determining your credit score.

In general, home equity loans are not always the best financing option for short-term expenses. For example, if you use a 10-year term home equity loan to purchase a car that you own for five years, you could end up paying more interest than you would with other financing options.

This is because you’re paying on the loan for a longer period than you likely would with a car loan. While a car loan may have higher interest rates, the term of the loan is not as long, so the financial benefit provided by using a home equity loan may be negligible in this case.

However, even with the example of car loans, there may be situations where a home equity loan is the right tool to help you achieve a brighter financial future. The best option will depend entirely on your unique set of circumstances.