Steps to Getting a Home Equity Loan
Before applying for a home equity loan, lenders will need to see you have equity in your current home. On average, lenders like to see borrowers having at least 15% to 20% equity in the property and a minimum credit score of 620.
Once the borrower can show evidence of equity in the home, the lender will then request the following documents to complete the loan application.
Proof of Income and Employment: If you are a W-2 employee, then you will need to provide the last 30 - 60 days of paystubs. You should also have the last paystub of the previous year or a copy of last year’s W-2.
If you are self-employed, you will need a few more items to complete the application. First, you must provide signed copies of the previous two years’ tax returns in their entirety. You will also need to provide an up-to-date profit and loss statement for the current year.
If you are retired, any income statements should be provided. This includes a recent Social Security statement or recent pension statement.
Homeowner’s Insurance: Simply login into your insurance portal (or call your agent) and request a copy of the Declaration Page.
HOA Dues and Fees: If you live in a community with a homeowner association, provide the most recent HOA statement showing the homeowner in good standing.
Assets: Your lender will want to see what assets you have available. Gather the previous 60 days worth of all bank statements, retirement account statements and any other brokerage accounts you may have. This includes a copy of the most current mortgage statement.
Debts (Liabilities): The lender will also want to see your current debt payments as compared to your income before approving your home equity loan application. This is called your debt-to-income ratio.
Most importantly, you will need to provide the most current mortgage statement as well.
Other Records: Your lender will also want to see records pertaining to divorce decrees, previous bankruptcy or foreclosure records, trust documents, and any other financial documents before they approve you for a home equity loan.
Pros and Cons of a Home Equity Loan
When financial decisions involve borrowing money, the borrower should always weigh the risk versus the reward of each loan option. Below are some of the most common pros and cons for a home equity loan.
Since the lender is using the equity in your home as collateral for the loan, interest rates for home equity loans are very competitive in the loan industry. In fact, home equity loans are often just slightly higher than rates borrowers see with primary mortgage loans.
Another advantage of a home equity loan is the tax break you get if you use the loan to improve your home. According to the IRS, the borrower will receive a tax deduction when the loan is used to “buy, build, or substantially improve your home.”
In addition to competitive interest rates and tax advantages, there are zero restrictions on how the funds from the loan can be used.
Like a HELOC, the debt created with a home equity loan is secured debt. This means if the borrower defaults on the loan, the lender can foreclose on the home to recoup any outstanding debt. Therefore, it’s imperative that the borrower is comfortable with and can afford both a mortgage loan and a home equity loan simultaneously.
Also, creating a home equity loan requires underwriting, and with underwriting comes closing costs. On average, closing costs can range between 2% and 5% of the loan. To put this in perspective, a $50,000 home equity loan could have closing costs between $1,000 and $2,500.
Another drawback of the home equity loan is if you unexpectedly have to sell your home. If this happens, the outstanding debt will have to be paid off in its entirety. This means if there was a sudden drop in value of your home, you’ll owe more than it could sell for and you would be on the hook for the remaining balance.
Lastly, and not necessarily a pro or a con, are points a borrower will pay towards a loan. Points, or discount points, are paid directly to the lender up front in exchange for a lower interest rate. This is also known as “buying down the rate.” The good news is this will lower your fixed monthly payment for the life of the loan; however, this also means the borrower will need to pay out of pocket to secure the loan. One point is equal to one percent of the loan (or $1,000 for every $100,000).
Frequently Asked Questions
Here are some of the most common questions when it comes to applying for and using a home equity loan.
Will a home equity loan affect my credit score?
Yes, a home equity loan can have both a positive and negative impact on your credit score. Whenever you apply for new credit, a hard inquiry will occur, which will initially lower your credit score. However, diversifying your debt and creating a history of on-time payments each month could increase your score over time.
Is the interest rate fixed or variable?
Typically, a home equity loan will have a fixed interest rate for the life of the loan. On the other hand, a home equity line of credit (HELOC) will have a variable interest rate.
Can I deduct the interest on my taxes?
Yes; however, the IRS has made it clear you can only get a tax deduction if the loan was used for home improvements on the home that is guaranteeing the loan.
Are there closing costs?
Yes, there will be closing costs and you may have the option to pay them out-of-pocket or to roll the closing costs into your loan. Keep in mind this will slightly increase your monthly payment.
How long does it take to get a home equity loan?
On average, a home equity loan takes about 45 days to close. Your home equity journey will start with the application on day one and the rest of the time is dependent on processing the application and underwriting the loan.
With the increase in home values over the past few years, home equity loans have become increasingly popular to utilize the equity in homes for things like home remodeling and consolidating high-interest debt.
Before you choose to go with a home equity loan, it’s always a good idea to weigh the benefits between a HELOC and a home equity loan to determine which will make most sense for your financial situation.
Check out the other posts about home equity loans!
Chris “Peach” Petrie is the founder of Money Peach. Money Peach partnered with OneAZ to provide free financial education to members across the state. To learn more about OneAZ’s partnership with Money Peach, click here.