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With a home equity loan or a line of credit, you can borrow money against the value of your home and use it for home improvement projects, college tuition, paying off higher-interest debt, or almost anything.
But when can you get a home equity loan or line of credit? And how much can you actually borrow?
Like any big money move, there are pros, cons, and risks. It’s important to keep in mind both a home equity loan and a home equity line of credit are secured loans for which your home is the collateral — meaning the lender can take your home if you default on repayment.
How Much Can You Borrow With a Home Equity Loan or HELOC?
Home equity loans and HELOCs work similarly, but are two very different things.
A home equity loan is a loan against the value of your home, paid to you in a lump sum. In this sense, it’s similar to a mortgage that you will have to repay in installments, with principal and interest.
On the other hand, a HELOC is a predetermined amount of credit, similar to how a credit card works. They are a revolving line of credit, meaning that if you have a HELOC of up to $30,000 but want to renovate your garage for $10,000, you’ll still have $20,000 left to use at a later time — or not.
Don’t accept the first offer you get — shop around with different lenders to get the best rate.
HELOCs typically last about 25 years, and are divided up into a draw period and a repayment period. The former is the time during which you can tap into the credit line, and you’ll only make interest payments on the amount you’ve drawn. The latter is when you’ll pay back the principal, as well as interest.
For a home equity line of credit, you may be able to borrow up to 85% of the appraised value of your home, minus the amount you owe on your first mortgage. For a home equity loan, you’ll be able to borrow up to 85% of the equity in your home, depending on your credit and how much other debt you have.
For example, if you owned a home worth $300,000 and owed $150,000 on your mortgage, you could open a home equity line of credit of $127,500 or get a home equity loan for $105,000. Here’s a simple example of how it breaks down with an example interest rate of 5%, which is currently in line with some of the best available HELOC or home equity loan rates:
|Home Value||Amount Owed on Mortgage||Max Amount to Borrow||Interest Paid|
|Home Equity Loan||$300,000||$150,000||$105,000||$5,250|
|Home Equity Line of Credit||$300,000||$150,000||$127,500||$6,375*|
Note: Most HELOC rates are variable, and you only pay interest on funds you actually use, so the exact interest you’ll pay with a HELOC depends on how much of the available credit you use, when you repay it, and whether the rate increases or decreases over time.
Of course, just because you might be eligible for the maximum amount doesn’t mean you have to sign for that amount — you should get a home equity loan or HELOC that aligns with your financial goals.
When and Where Can You Tap Into Your Home Equity
To get approved for a home equity loan or a HELOC, you will need to show you have significant equity in your home. Most lenders will require that after the loan or HELOC is issued, you still have at least 15% to 20% in equity in your home, says Elliot Pepper, CPA, CFP and co-founder of Northbrook Financial.
For example, if you own a home valued at $500,000 and owe $250,000 on a mortgage, you have 50% equity in your home and can get a loan or HELOC up to about $150,000, depending on your credit. This would in turn reduce your equity, but still keep it at 20%. You would have debt of $400,000 against a house worth $500,000, Pepper explains.
While you can technically get a home equity loan or a HELOC as soon as you own a home, it typically takes some time to build up the necessary amount of equity. If you’re considering one, the best time to do so is when you have the cash flow, little or no consumer debt, stable employment and good credit, with a score of 720 or higher for the best interest rate, says Lindsay Martinez, owner and financial planner of Xennial Planning LLC, a financial planning firm.
You should also familiarize yourself with the “loan-to-value ratio,” which is simply the amount of the loan compared to the value of the property. To calculate it, divide the total mortgage amount by the appraised value of the property. The lower your ratio is, the lower the interest rate can be, all other factors being equal — that’s because the lender will consider borrowers with a lower ratio to be less of a risk. You can get the best rates when the ratio, which you’ll often see referred to as LTV ratio, is below 80%.
Whether you are looking for a home equity loan or a HELOC, asking your bank is a good place to start.
“Most large banks and financial institutions offer home equity loans, so it’s always a good idea to solicit a few quotes and compare the terms, especially the interest rate and other fees, to make sure you get the right loan for you,” Pepper told us earlier this month.
However, you do not need to get a home equity product from your original lender; you can shop around for the best interest rate, lowest closing costs and shortest timeframe to close. Martinez also suggests asking a prospective lender to meet or beat the terms of another.
Since both home equity loans and HELOCs require you to use your home as collateral against the loan, keep in mind that you might lose it if you are unable to repay. With that in mind, make sure that you apply for one only if you have a solid plan for using the money.
“You should not take a home equity loan for personal expenses such as a boat or fancy vacation,” Martinez told us. You should only use home equity loans or lines of credit to fund expenses resulting in long-term gains; those include home improvement, college costs, and even paying back higher-interest debt, for example from credit cards.
Checklist: What You Need to Borrow Against Your Home Equity
If you’ve decided that borrowing against home equity makes sense for you, it’s time to get your documents in order. Before you go to the bank of your choice and ask them for either a loan or line of credit, here’s what you should have on hand:
- Personal information about you and any co-borrowers (Social Security number, date of birth, marital status, employment status, residential status)
- Information about your home including purchase price and date, property type, estimate of your property value
- Information about all your debts and payment obligations. This includes mortgages on the property, car and student loans, and credit card debt
- Employment history and current income
Before entering the process, make sure you have a credit score at least above 620 (or 720 to get the best interest rate) and that your debt-to-income ratio is 43% or lower. This may mean having to wait until you have boosted your credit score and/or reduced your debt relative to your income. Making early payments on credit card balances is a way to help your score rise in the short term, for example.
Home equity loans and home equity lines of credit are a great way to tap into the value of the biggest asset you are likely to own.
By borrowing money against your house, you also can end up increasing its value if you use the funds for home improvement. But that strategy can also work to pay off debts carrying a higher interest, such as credit card debt, or to cope with other major life expenses.
After shopping around to find the best rate and terms for you, keep in mind that you’re borrowing money against your home, and that you’re putting it on the line if you find yourself unable to repay.