February 20, 2020

Edited 05/19/20

Home Equity Loans: Everything You Need to Know

“There’s no place like home.” Your home is not only a hub for special memories with your loved ones, but also a major financial asset for retirees. One of the best ways to use your home to your advantage is with home equity loans. They can help fund any emergencies or short-term large expenses you may come across during retirement, as well as help you consolidate and pay off high-interest debts and credit cards.

What are Home Equity Loans?

Home equity loans are secured loans that use your home as collateral. They are a type of second mortgage and are only available if you have built up enough home equity. 

Home equity represents the amount of your home you actually own. Your home equity increases over time as you make payments against your mortgage and/or the value of your property appreciates.

However, when you take out a home equity loan, your home equity decreases. Home equity loans are a great way to borrow cash quickly and at a lower rate to pay off high-interest credit card or student loan debt, and can be used for large expenses such as education costs, renovations or any unexpected expenses you encounter in retirement.

How Do Home Equity Loans Work?

Qualifications for a Home Equity Loan

The requirements to qualify for a home equity loan are typically easier than other loans because your home is being used as collateral. You must have:

  • Built-up enough home equity (usually 15% to 20%)
  • Credit Score of 620+
  • Debt to Income Ratio (DTI) is between 43% to 50%
  • Documented ability to repay the loan (Recent W-2 statements, bank statements, etc.)

How to Repay Your Home Equity Loan

Home equity loans can be an efficient way to pay for education costs, home renovations, unexpected expenses, and other expenses where you know the amount you need to borrow. You repay this loan at an annual fixed interest rate through monthly payments. Terms for this type of loan can be anywhere from 5 to 30 years.

When taking out a home equity loan, make sure you’re doing your research and finding the best rate possible.

Benefits of a Home Equity Loan

There are several benefits to taking out a home equity loan:

  • Low-interest rates: Home equity loans are secured debts so interest rates are typically lower than unsecured debts, such as a credit card.
  • Fixed interest rates: Fixed rates provide predictability and allow you to budget for repayments more easily.
  • Quicker close time: Home equity loans can allow you to receive money faster than with other loan options. This can be valuable if using the loan proceeds for an unexpected need.
  • Tax benefits: Loans you use to “buy, build, or substantially improve your home” are tax-deductible.

Downsides to a Home Equity Loan

While home equity loans are a great solution to get a large amount of cash quickly, there are drawbacks:

  • Losing your home: By failing to make repayments, you risk losing your home to foreclosure and hurting your credit and finances.
  • Borrowing costs: Lenders often charge a borrowing cost for home equity loans, so before making your decision, make sure you’re not paying an unreasonable interest rate.
  • Selling your home: Similar to a first mortgage, if you decide to sell your home, you will have to repay the entire loan immediately.

Alternatives to Home Equity Loans

Home Equity Line of Credit (HELOC)

One common alternative to home equity loans is a line of credit, i.e. HELOC. HELOCs are another type of secured debt that uses your home as collateral. However, instead of receiving all your money at once, you will receive a credit line which you can use as needed. As you repay your outstanding balance (i.e., the amount you borrowed), the amount of available credit is replenished. This means you can borrow against it again if you need to, and you can borrow as little or as much as you need. Repayment rates are also variable, unlike with home equity loans. In addition to helping pursue a longer-term investment strategy with cash that may have been set aside in a savings account for emergencies, HELOCs can also help pay off high-interest debts, such as from a credit card. 

Reverse Mortgage

Reverse mortgages allow for equity in a home to be converted into a monthly income. In exchange for the equity in your home, a lender provides a monthly stream of income, typically for life. The loan is repaid when the borrower passes away and the property is sold. While this reduces your home equity, it is an option for those that need income.

Cash-Out Refinance

A cash-out refinance replaces the current loan on your home with a new loan that is greater than the current mortgage on your existing home. You will need to take the proceeds from the new loan and pay off the old loan. That way, the difference between the existing mortgage balance and the new amount that you borrow can be used to pay off high-interest debt, renovations, or any other expenses you may have. Similar to home equity loans, you must have enough home equity to qualify for cash-out refinancing. 

If you’re considering a loan, weigh the pros and cons of home equity loans and how they work and make the decision that is best for you.