A home equity loan lets you borrow against the equity in your home to get cash for renovations, debt consolidation or other large expenses. These loans come in several forms, and their interest rates tend to be lower than rates for other types of credit, like personal loans. But you secure the loan with your home — meaning your home serves as collateral — and you risk foreclosure if you’re unable to repay the loan, so it’s important to understand your home equity loan and its costs before you borrow.
Keep reading to learn more about home equity loans and how to qualify for the best home equity loan rates.
What Is a Home Equity Loan?
A standard home equity loan is an installment loan that pays out a lump sum and charges a fixed interest rate. This type of loan is fully amortized, meaning that you pay down your principal each month and fully repay the loan by the last payment date.
A home equity loan can be a first or second mortgage, depending on how your loan is structured and whether you already have a loan secured by your home.
What Is a Home Equity Line of Credit?
A home equity line of credit, or HELOC, differs from a standard home equity loan in some important ways. Rather than paying out the full loan amount you’re approved for, a home equity line of credit lets you draw only the amount you need, up to your credit limit, for a specified length of time.
The loan is a revolving account, like a credit card, during this draw stage, and you can make minimum payments that might not repay the entire principal balance by a specific date. A HELOC only becomes amortizing after the draw period ends and the repayment period begins.
Because HELOCs typically have adjustable interest rates, you could be in for a nasty surprise if you’ve maxed out your line of credit and made only minimum payments during the draw phase.
Find Out: How Is Interest Calculated on a HELOC?
What Is a Reverse Mortgage?
Older homeowners with sufficient equity can take out a reverse mortgage, also known as a home equity conversion mortgage, to tap into that equity without having to make payments on the money they borrow. The loan becomes due after the homeowner dies or stops using the home as their primary residence.
Home Equity Loan Interest Rates and Closing Costs
Your lender charges two types of fees on home equity loans: interest and closing costs. Closing costs typically amount to 2 to 5 percent of the loan amount, and they include things like points, the application fee, title search, appraisal and, in some cases, a maintenance fee.
The interest rate is the cost of borrowing money, and rates vary by lender as well as by the loan type, the property you’re borrowing against and the strength of your credit. Interest adds thousands of dollars to the amount you ultimately repay, so it’s worth doing whatever you can to get the best home equity loan rate. Here are some tips to get you started:
- Clean up your credit report: The better your credit, the better your loan rate, in most cases. Before you apply for a loan, make sure to check your credit. Start early to give yourself time to correct mistakes and pay off any old collection accounts you might’ve forgotten about.
- Don’t borrow too much or too little: Conforming loans, which meet Fannie Mae and Freddie Mac guidelines, typically have lower interest rates than unusually small or large loans.
- Don’t draw all your equity: Lenders typically allow you to borrow up to 85 percent of your equity. This figure includes other mortgages and closing costs for the new loan. Borrowing less than that reduces your lender’s risk and might earn you a reduced rate.
- Shop around: Use annual percentage rates to compare loans from different lenders. The APR includes the loan interest rate plus any other fees your lender charges, such as points. Because it’s more comprehensive, the APR more accurately represents the cost of your loan than interest rate alone does.
- Do a cash-out refinance: Second mortgages typically have higher interest rates than first mortgages do. Rather than take a second mortgage, consider a refinance loan that would allow you to pay off your first mortgage and still give you enough cash to cover the expenses for which you planned to use the home equity loan.
- Borrow from a bank you’re already using: Some banks offer their deposit-account customers discounts on loan rates.
Borrowing against your house is a big step. Understanding your loan options and the costs associated with each helps ensure that you’ll choose the loan that best meets your needs.
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