How Does a Home Equity Loan Work?

A home equity loan can be used for anything, but most people like to use it for upgrades to the home or to pay off high interest debt, such as credit cards or vehicle payments. Often, if there is enough equity in the home, a borrower will take out a home equity loan to complete upgrades and pay off all other debt.

A home equity loan can be procured from any bank – it does not have to come from the same bank that holds the mortgage on your home. When you apply for the home equity loan, the loan officer will check for the following:

1. Your credit score: Does your credit score qualify you for that particular bank’s credit?
2. The amount of equity in your home: How much is owed on the loan and what is your home worth?
3. Debt to Income Ratio: How much debt does the applicant have in comparison to his income?

If your credit score is high enough for the bank’s program, the underwriter will look at the next step. Your credit score does not have to be top-notch to get a home equity loan, especially if you are paying off other debt, but mortgage payment history should be perfect for at least three years prior to applying for the home equity loan.

If your credit qualifies, the underwriter will look at the amount of equity in your home. You will more than likely have to pay for an appraisal of your home. The bank usually picks the appraiser. Once the home is appraised, the underwriter will compare the home’s worth with the principal amount due on the mortgage (value minus amount owed equals equity). If you are applying for $75,000, and the equity in your home is at least $75,000, you qualify for the home equity loan, and the underwriter will move to the next step.

If you do not have enough equity in the home, the loan will be denied for the amount you requested. Depending on the bank, it will be an outright denial, or the bank may offer you a lower home equity loan – one that matches the amount of equity in your home.

Once you get past this, the underwriter will look at the debt to income ratio. The mortgage payment can be as high as one-third of your gross income. If all other debt takes most of your income, and you are not paying off debt with the home equity loan, you cannot afford the loan, and it will most likely be denied. If you are paying off other debt, the home equity loan will most likely be approved, since you will be paying off debt, making your debt to income ratio more manageable.

Once you receive the home equity loan, you will not have the same amount of equity in your home, since the home equity loan has “eaten up” the equity. As you pay the home equity loan and the mortgage principles down, the equity rebuilds. Unlike mortgages, home equity loans generally do not have an early pay-off penalty. The interest rate on home equity loans is usually lower than mortgage interest rates. The payments are also for a shorter period of time, which means you pay less interest on the home equity loan (over time) than you do on the mortgage, especially if you pay extra on the principal each month.