Whatever your got-to home buying strategy is—a cash buyer or home loan diva—we've put together…
A house you haven’t fully paid for can be a liability, but what if you can use the equity you have built in the home to create another income-generating possibility?
If you run into an emergency or find any need for a lump sum of cash, a home equity loan might provide what you need. However, we don’t recommend using the funds from this kind of loan for something that will not earn you any income. If you end up defaulting on your home equity loan, you can end up losing your house.
Getting a home equity loan can be a perk of homeownership, but you need to understand if it will have benefits or drawbacks for your situation.
So what is a home equity loan, and how do you know if you are qualified?
Home Equity Loans
When you get a mortgage, your house becomes the collateral in case you default. The same goes for a home equity loan. If you get this type of loan, this means that you are already paying for a mortgage. The collateral for this new debt won’t be the whole house but the partial ownership you’ve gained since you started paying for your home loan.
While you are paying for your mortgage, little by little, you gain homeownership. This is called your home equity, which represents how far along into your mortgage you’ve paid compared to when you started. For example, if you make an initial 20% down payment on your house, this is 20% home equity. Every time you make a monthly payment, you add to this percentage of homeownership. Then, based on the appraised value of your home, you can borrow part of that money you’ve already paid into the mortgage for something else you might want to do. For this reason, a home equity loan is often referred to as a second mortgage.
Home equity loans have a fixed interest rate. Like a mortgage, you can pay for it for up to thirty years, although you can choose to pay for it for as short as five, keeping in mind that the longer the loan term, the more outstanding your debt. Unlike home loans, though, you get a lump sum payment equivalent to 85% of your stake in the house.
The lender’s risk in a home equity loan is a lot higher than for your original mortgage. Due to this, home equity loans tend to have a higher interest rate compared to mortgage loans. You have to consider this, especially if you don’t expect a massive bump in your monthly income.
One of the reasons people apply for a home equity loan is that it can be much easier to qualify for than personal loans. From the lender’s perspective, you have more skin in the game because you can lose your house if you stop paying for this loan. In addition, with your home as collateral, you can get approved faster for a relatively large loan amount.
Home Equity Loan Alternatives
When you start reading about home equity loans, you will also encounter cash-out refinancing. This works very similar to home equity loans, but you can borrow against any property you have that has significant value for cash-out refinance. For example, you can also do a cash-out for a car or another type of property. If you use your house as collateral, a cash-out will replace whatever mortgage you currently have.
As the terminology implies, you also get a lump sum for the appraised value of your home. The interest rate is also fixed for the whole loan term. Unfortunately, you can only borrow up to a maximum of 75% loan-to-value for this kind of loan. In addition, a 25% down payment has to be made. So that can be a factor for you in deciding whether this is the type of loan you want to get according to the amount of money you will need.
Another point that can influence your decision is if you are happy with the mortgage you are paying for monthly. For example, say you have a conventional loan and like the terms or the interest rate you were given. You can choose to keep that and get a home equity loan. On the other hand, say you have an FHA loan with mortgage insurance for years and years. Getting a cash-out to refinance will be a better idea because you’ll be able to eliminate the FHA loan terms and pay for a cheaper mortgage.
Home Equity Line of Credit
An alternative you might look into that also taps into your home equity but offers a different method is a home equity line of credit or HELOC.
If you mean to get a lump sum payment for the equity you have for a one-time situation, you need a home equity loan (or cash-out refinancing if that’s what you prefer). On the other hand, if you need a revolving type of credit, this is when you get a HELOC.
A HELOC turns your home equity into a credit card issuer. You can borrow money from it whenever you want and choose only to use parts of it every time. Whenever you pay, your limit refreshes, then you can borrow again.
Unlike credit card debt, a HELOC is a secured loan, so you lose your house if you default on your payment. For this reason, if you already have a credit card, getting a HELOC can be very risky, especially if you won’t be able to put the money towards investment. It can also be redundant if you are not maxing out your credit card limit for whatever you need.
HELOCs also have charges similar to the annual membership fees of credit cards. If your account becomes inactive, the bank can decide to lower your limit. When this happens, your credit score can take a hit. So when you get a HELOC, you have to make sure you’ll be able to use it, and the costs will be reasonable for your purpose.
What Option to Take
Whether you are thinking of getting a home equity loan, a HELOC or a cash-out refinance, there’s only one question you have to be sure of answering: why do I need to borrow this money?
Do I need to pay a bill? Am I buying another kind of investment? Will I lose money when I get this new loan?
If you feel strongly about your reason, you can then decide what kind of debt you want to become responsible for to be at peace with the applicable fees.
Since a HELOC works like a credit card, it’ll be something you’ll have to maintain. If there’s no activity, or you don’t even end up using it, that’s just money down the drain. Now, if you choose to go for a home equity loan or a cash-out refinance, these come with closing costs and fees, so you might want to reflect if you’ll be able to pay for these additional charges.
Home Equity Loan Credit Score 650
If you have a 650 credit score, you must be wondering if you have a chance of qualifying for a home equity loan. Although the requirements may vary according to lender, a credit score is a common requirement for loans. However, aside from credit, other significant factors can affect your eligibility for a home equity loan.
Answer these questions to know if you can qualify:
- Do you have at least 20 percent home equity?
- Is your debt-to-income (DTI) ratio lower than 43 percent?
- Do you have at least two years’ steady employment?
If you answer yes to all of these, you have an excellent chance of getting approved for this type of loan because the minimum credit score needed for a home equity loan is just 620.
As in a mortgage, your credit score can also affect the kind of interest rate you can get for a home equity loan. The higher your credit score, the better. If you have a lower credit score than when you applied for your first mortgage, we advise thinking further if it’s an excellent time to take on this loan.
Since your approval rests on the lender, there are still ways you can make up for the weak areas in your application. For example, say you have a 650 credit score, but the lender you are dealing with actually prefers a 670, which is the starting score for good FICO Scores. If you don’t meet this requirement, you can impress the lender another way if you already have more than enough equity in your house or you have a meager DTI ratio, like 30 percent. You can also show that you can make monthly payments with a stable income or a high salary.
If your main worry is your credit score, the good news is, home equity loans are a lot more lenient about bad credit compared to mortgage applications. As a result, you’d be more likely to qualify for a home equity loan than a personal loan. All you have to do is take a chance!
What to Do in Your Scenario
As we’ve mentioned, when you apply for a home equity loan, someone will come along to appraise the current value of your home. If your property value has significantly risen compared to when you bought it, then getting a home equity loan can be the perfect decision to make today.
Unlike home equity loans, a first mortgage can be hard to qualify for, especially if you start with a less than 20% deposit. On the other hand, home equity loan borrowers already start with enough equity under their name. At this point, you might have a better credit history or more experience taking on debts.
We recommend evaluating how exactly you want to borrow money. For example, based on your purpose, do you want to cash out your equity, or do you want to prepare for unforeseen circumstances by getting an additional line of credit?
If you are serious about upping your loan application chances, we suggest doing the following:
- Work on boosting your credit score. Earning just 20 more points will already get you out of bad credit.
- Improve your debt-to-income ratio. See if you can pay off the remaining balance on your other loans or get a salary bump in your employment.
- Shop around for different home equity lenders. It’s the same as when you were looking for your first mortgage. You want to get the company that can give you the best interest rate and terms.
As long as you haven’t submitted your application, time is on your side, so see that you make the most out of it.
How much equity have you earned at this point?