The Homeowner’s Guide to Home Equity Loans and Lines of Credit

Your home is likely your biggest asset now, and perhaps in the future. For many, this means building equity in their home as they make regular mortgage payments. If you feel your credit is stretched or you’re struggling with multiple monthly payments, the equity in your home can serve as a powerful tool to improve your financial health. With home equity loans and lines of credit, you can get the funding you need to pay off smaller, high-interest debt and save money in the long-term.

We have developed this guide to give you a better understanding of home equity loans and lines of credit. First, we provide a broad overview of each type of financial product, the requirements you need to fulfill to qualify, and how to use these products to benefit you, instead of simply taking on more debt.

What Is a Home Equity Loan?

Credit unions, banks, and other lenders offer homeowners the ability to borrow a large chunk of money against the equity they have built in their homes. Homeowners use their house as collateral, so home equity loans are for all practical purposes the same as a second mortgage. The terms of a home equity loan vary based on lenders, the amount a homeowner borrows, their creditworthiness, and their overall financial situation. Repayment takes between five and 30 years and you can use funds for anything you want including remodeling, debt consolidation, paying for a big life event, and college tuition.

What Is a Home Equity Line of Credit (HELOC)?

A home equity line of credit (HELOC) also provides a way for homeowners to borrow against their home’s equity to get the funds they need. In contrast to a home equity loan, a HELOC works more like a credit card because it is a revolving line of credit. Your lender gives you a limit and you can use as much as you want at any time. Most HELOCs come with checks and a credit card connected to their account. Repayment terms are monthly on the amount you borrow and your home is also collateral.

How Much Can You Borrow With a Home Equity Loan or HELOC?

Your financial situation will determine the exact amount you can borrow with a home equity loan or the amount of your home equity line of credit. According to the Federal Trade Commission (FTC), homeowners with excellent credit can borrow up to 85 percent of the appraised value of their home, minus the debt of their first mortgage. This is your loan-to-value ratio. For example, if your home was appraised for $200,000 and you still owe $100,000, you could borrow up to $170,000 minus your mortgage debt. This means your home equity loan or HELOC could be as much as $70,000. Lenders might not take as much of a risk with those with lower credit ratings. If your credit is less than perfect, you likely will not be able to borrow against all of your equity.

How to Qualify for a Home Equity Loan or HELOC

Both types of home equity financial products use your home as collateral. Provided you have the equity, your credit does not need to be perfect to qualify. Yet, lenders still want to make sound borrowing decisions. If you plan on applying for a home equity loan or a home equity line of credit, you will need to meet most if not all the following requirements:

Minimum of 15% Home Equity

While it might be obvious, you must have equity in your home for a home equity loan or HELOC. Most lenders want at least 15% to 20% equity to qualify.

Dependable Income

Whether you are employed, self-employed, or have other income sources, you need to provide proof of regular income and secure employment, when applicable. Regular income is especially important if you’ve changed jobs a few times.

Low Debt-to-Income (DTI) Ratio

Your debt to income is the comparison of your total monthly payments, including your payment for the new loan, with your total monthly income. Your DTI ratio cannot be more than 36% in most cases; however, some lenders will allow borrowers to have a DTI ratio of up to 50%. If you have a short credit history or your credit is less than good, lenders might reduce the maximum DTI ratio for a home equity loan or HELOC.

Good Credit Score

Your credit score is a measure of your creditworthiness and you’ve likely interacted with it before when buying your home and making other large purchases. Exact credit score cut-offs for a home equity loan or HELOC vary among lenders, but in most cases, you will need a credit score of at least 620. Your credit score also helps determine your interest rate. The general rule of thumb is that the better your credit score, the better your interest rate.

Common Uses for Home Equity Loans and Home Equity Lines of Credit

You can use your equity any way you see fit, but some general guidelines apply between these two types of financial products. Many homeowners use home equity loans for large purchases and expenses because interest rates are typically lower than a credit card and other unsecured personal loans. Homeowners can spread a large loan amount over a longer period of time. In contrast, many homeowners resort to a HELOC for shorter-term financial needs, whether a minor home renovation project or quarterly college tuition for a child.

Using Your Equity to Improve Your Financial Health

Borrowing money against the equity in your home doesn’t simply amount to an accumulation of more debt. If your credit is less than perfect, you can use a home equity loan or a HELOC to build your credit and improve your financial health, especially those components of your financial situation that lenders use to qualify you and set terms for loans and revolving credit. The following tips can help you improve your debt-to-income ratio, reduce total monthly output, increase your credit score, potentially increase the value of your home, and help you meet long-term goals for savings and investment.

Consider Debt Consolidation

If you are making multiple monthly payments on personal loans, store credit cards, and other high-interest credit cards, you have a good chance of reducing your monthly output if you consolidate your debt with a home equity loan or HELOC. If you have enough equity to pay off all of your debt except for your mortgage, you likely can reduce your monthly output for debt payment. In most cases, borrowing against your equity is cheaper than the interest rates on used car loans, boat loans, credit cards from major department stores, and more. Not only can you reduce your monthly output, but you can save money with lower interest rates.  If you put your savings towards your loan, you can also see your debt-to-income decrease.

Renovate or Remodel Your Home

Taking on home improvement projects is a common reason that homeowners take out a home equity loan or a HELOC. Renovations can be expensive and your home’s equity is the perfect source of income to get the job done, whether remodeling your kitchen, building a new deck, upgrading floor coverings, or any other project. Not only will you benefit from new and improved areas in your home, but you increase the value of your home. Additionally, when you use a home equity loan or HELOC to fund your home improvement projects, the IRS may allow you to deduct the interest you pay on your taxes.

Improve Your Credit History and Increase Your Credit Score

If your credit is less than perfect, but you are still able to get approved for a home equity loan or home equity line of credit, you can use your equity to improve your credit history and increase your credit score. Credit bureaus look at how many credit cards and loans you have, your total debt, and if you pay on time to determine your credit score. Taking out a HELOC or home equity loan allows you to potentially reduce your overall debt if used for debt consolidation, reduce the number of revolving credit lines you have that are carrying a balance, and make consistent on-time payments, altogether lengthening your credit history. Depending on your financial situation, you might see a fairly quick increase in your credit score. You can also use a HELOC to pay for monthly expenses and pay the balance each month to help build your credit.

Save for a Rainy Day or Retirement

If you are looking to build your credit and don’t have any other specific reasons to take out a home equity loan or HELOC, consider using your equity to meet your savings and retirement goals. Maybe you need to build an emergency fund or you want to invest in an individual retirement account (IRA) or an educational savings account (ESA) for your children. As you make your new payments, you improve your credit and secure your financial future.

Considerations for Home Equity Loans and Lines of Credit

Home equity loans and HELOCs both use the equity in your home to provide you with the funds you need for debt consolidation or life’s big purchases. Yet, the differences in these financial products sometimes make one better than the other in some situations. Additionally, homeowners should be aware of the risks associated with borrowing against their home’s equity, so they do not fall victim to common mistakes. Before you choose between a home equity loan and a HELOC, consider the following:

Closing Costs

When you take out a home equity loan, you must pay fees and closing costs like you did on your initial mortgage. After you apply for the loan with your lender, they will provide you with an estimate of the costs, so you aren’t surprised. You should make sure that the amount you need to pay in fees is worth taking out the loan. In comparison, HELOCs typically have no application fees, or annual fees, sometimes making it the better choice for borrowing small amounts.

Interest Rates

Home equity line of credit rates are often a little more than home equity loan interest rates, for two reasons. First, the advertised APR for a HELOC does not factor in points and finance charges, as the rates advertised for home equity loans, so HELOCs sometimes appear to be less expensive. Second, if you take a home equity loan, your interest rate will be fixed for the length of your loan. In contrast, HELOCs have variable interests that can change. If you see a drastic change in your interest rate, borrowing from your HELOC could be costly. This is only an issue if you carry a large balance.

Reloading

Reloading is the term lenders use to describe borrows who take loans out to pay existing debt, open up more credit, and make more purchases. Homeowners who are stuck in this type of spending and borrowing cycle typically continue to increase your debt. At some point, this cycle can financially overwhelm homeowners and lead to disaster. Stopping the cycle might require a homeowner to walk away from their house because they can no longer afford their payments. You can avoid reloading by carefully evaluating your financial health prior to borrowing against your home. Make the effort to understand the terms of your loan or line of credit to ensure you will be able to repay the debt without putting other bills in jeopardy

Contact Dane County Credit Union to Learn More About Your Home Equity Options

Residents of Dane County and the Greater Madison area can visit Dane County Credit Union, which has proudly served the area since 1935, for all of their banking needs. Contact us today to learn more about requirements and your eligibility for a home equity loan or a home equity line of credit. Our knowledgeable and sincere team of Member Service Representatives can help find the right financial solution for your needs.

 

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Jen M.

Jen has been with DCCU since she graduated from UW Madison - a long time ago. As the Content Strategist she helps share all the amazing things DCCU does in our community and spreads the credit union philosophy of People Helping People. When she's not working for the best credit union in south central Wisconsin, she's busy with 4 kids and a feisty little dog at home. She formed her family through adoption and has a deep passion to support foster and adoptive parents and kids. Her favorite place to relax is poolside or in front of the fireplace.