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What is a home equity loan?

Home equity loans often come with lower interest rates than other credit options like credit cards and personal loans. Getty Images

Between stubborn inflation, higher interest rates and other economic concerns, Americans are feeling the pinch. Given the current state of the economy, many are looking for options to make ends meet or pay off debt.

Those strapped for cash may turn to credit cards or personal loans to get through a rough financial spot or tap into their 401(k) for funds to pay down debt balances.

Another option to access cash is to take out a home equity loan. These loans have numerous advantages but are not ideal in other scenarios. It really depends on your personal situation. Before you proceed, it's essential to gain a better understanding of home equity loans. You can check your home equity loan options online here now to see if it's right for you.

What is a home equity loan?

A home equity loan is a second mortgage that allows you to borrow a lump sum of money against the equity in your home. Like your first mortgage, a second mortgage is secured by your property.

Home equity is the difference between your home's current value and the amount you owe on your mortgage. For example, let's say you initially purchased your home for $300,000. Over time, your home's value rises to $400,000 while your monthly payments lower your loan balance to $250,000. In this scenario, you would have $150,000 in home equity ($400,000 -$250,000).

Generally, lenders will let you borrow 80% of your home's equity, or 80% loan-to-value (LTV). So using the above example, you may be able to borrow $120,000 (80% of $150,000).

Home equity loans usually have fixed interest rates, and repayment terms range from five to 30 years. The interest rate you receive will depend on numerous factors, including your income, credit history, home value and the existing balance on your home loan.

Benefits of using a home equity loan

Home equity loans boast several benefits, such as:

  • Lower interest rates: Since your home secures the loan and reduces your lender's risk, home equity loans often come with lower interest rates than other credit options like credit cards and personal loans.
  • Possible tax deduction: The IRS may allow you to deduct the interest on your home equity loan if you use the funds to build or make significant improvements to a qualified residence. Consult with your accountant or tax professional to determine your eligibility for this deduction.
  • Easy to budget: With a fixed interest rate, your payment remains the same over the life of the loan. As such, you can include your costs in your long-term budget and plan accordingly.

If you think you could benefit from using a home equity loan then get started today. Check eligibility and your local offers here.

How to apply for a home equity loan

Before applying for a home equity loan, make sure you'll have at least 20% equity in your home remaining after taking out the loan. Lenders typically look for a credit score of at least 620 and regular on-time payments on your existing mortgage. Maintaining a debt-to-income ratio (DTI) of 43% or less is also important. DTI measures the amount of your monthly debt bills against your monthly gross income.

If you have adequate equity and you want to take out a home equity loan, follow these steps:

  • Get loan estimates from multiple lenders to compare rates and repayment terms.
  • Select the loan offer that best suits your needs.
  • Review the disclosure documents that detail the terms of the loan agreement and proceed only if you agree.
  • Get a home appraisal if your lender requires one, and submit any supporting documents your lender requests.
  • Close on the home equity loan and receive funding, typically in one lump sum.

Remember, the Truth in Lending Act (TILA) protects your right to change your mind and cancel your loan without losing money, so long as you do so within three days.

When a home equity loan may not be beneficial

In certain scenarios, a home equity loan may not be your best option.

You might consider other options if the interest rate on a new home equity loan is higher than your existing accounts or other forms of credit. For example, if you plan on using funds from a new loan to consolidate debt, it may not be advantageous if current home equity interest rates are higher than those on the debts you wish to pay off. Current home equity loan rates generally range from 5% to 16%.

The most significant disadvantage of a home equity loan is that it puts your home at risk if you don't make your payments. If your source of income is unreliable or you carry a substantial amount of debt, getting a home equity loan probably isn't your best financial move.

Financial experts typically recommend against getting a home equity loan or home equity line of credit (HELOC) for short-term expenses like an expensive vacation or wedding. Depending on your loan term, you could pay interest on the loan amount for years or even decades, long after you've enjoyed the benefit.

The bottom line

A home equity loan is a valuable tool to help you tap into your home's equity for cash you can use to pay for home repairs, renovations and other purposes. If you're considering a home equity loan, run the numbers to make sure it makes financial sense. Remember to account for closing costs on a new home equity loan, typically 2% to 5% of the loan amount.

Also, consider alternatives, such as a HELOC. A HELOC is a credit line that works like a credit card. It allows you to borrow only what you need in smaller increments as needed, up to your approved limit. Like a home equity loan, your home secures your HELOC, which puts your home at risk.

If you plan on taking out a home equity loan, get multiple loan estimates and select the loan offer with the interest rates and terms that are most advantageous for you. You can easily explore your home equity loan options here now or by using the table below.

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