Why Refinance?
- Get a lower rate
- Reduce monthly payment
- Remove mortgage insurance
- Customize your term (+ or -)
Earn cash back
after close!
With Home Connect, you could earn $350 to $9,500 cash back after close.
Buying a home with a mortgage may come with a monthly payment, but it also gives you the chance to build equity. Equity is a financial resource you can tap into for various needs, including home renovations, debt consolidation or education funding, to name a few.
How can you convert valuable home equity into usable cash? The answer is a home equity loan. Even better? It won’t impact your primary mortgage rate.
Let’s explore what a home equity loan is, how it works, what you need to get one and how it differs from other home equity products.
What Is a Home Equity Loan?
A home equity loan lets you borrow money using the value you’ve built up in your home. This value, called equity, is the difference between what your home is worth and what you still owe on your mortgage. A home equity loan is sometimes referred to as a second mortgage since you get a lump sum of cash and make regular payments on top of your existing mortgage.
You can use a home equity loan for a variety of purposes, from remodeling to debt consolidation to educational expenses. It’s a flexible financial tool for accessing funds if you need them.
How Does a Home Equity Loan Work?
Like other loans, you’ll need to apply for a home equity loan and meet certain qualification criteria. Once approved, you will typically receive the full loan amount upfront. Then, like your current mortgage, you’ll make regular monthly payments, including both principal and interest, over a set term.
Your monthly payment amount depends on the loan’s interest rate and term. Shorter-term loans typically have higher monthly payments but result in less total interest paid over time. Longer-term loans have lower monthly payments but incur more interest over the life of the loan.
Pros and Cons of Home Equity Loans
Home equity loans offer numerous benefits and some potential drawbacks:
Pros
- Doesn’t impact your primary mortgage rate. Your current mortgage rate remains unchanged.
- Easy to budget. Home equity loans have a fixed monthly payment for the entire loan term. Regardless of market fluctuations, you'll know exactly how much you'll need to pay each month.
- You receive your funds in a lump sum. Depending on your equity and financial situation, you may be able to borrow a substantial amount. These funds can help you cover significant expenses, like an expensive home renovation.
- Potential tax benefits. The interest paid on a home equity loan may be tax deductible if the funds are used for home improvements. Consult with a tax advisor to discuss your specific situation.
- Lower interest rates than other types of loans. Home equity loans often come with lower interest rates compared to personal loans and credit cards.
- Potential to build more equity. Using a home equity loan to invest in home improvements can not only enhance your living space but also boost your home’s market value. A higher market value means more equity and potentially a larger profit when you sell.
Cons
- Closing costs. Home equity loans usually have closing costs, which add to the loan’s overall costs.
- Your home is the collateral. As with any type of mortgage, if, for some reason, you’re unable to keep up with your loan payments, the lender could eventually foreclose on your home.
- Increased debt. As with any other loan, a home equity loan increases your debt load.
- Reduced home equity. A home equity loan taps into the equity you’ve built up. However, as you pay off your mortgage and home equity loan, your equity will increase again.
- Overspending risk. It can be tempting to borrow more than you need or can comfortably afford to repay.
When considering a home equity loan, it’s important to weigh the pros and cons carefully. Take time to assess your financial situation and goals before deciding if this type of loan suits you.
How to Qualify for a Home Equity Loan
While your home equity offers a potential source of funds, a lender will assess your financial situation before approving a home equity loan. They want to ensure you can manage the additional debt. Some of the criteria typically required to qualify for a home equity loan include:
- Sufficient equity. Most lenders require at least 15-20% equity to be remaining in your home after the loan closes.
- Strong credit score and positive credit history. You will need to demonstrate creditworthiness.
- Adequate debt-to-income (DTI) ratio. Your DTI shows lenders how much of your income goes towards debt. A low DTI, typically 45% and under, demonstrates you can manage additional debt responsibly.
Getting a Home Equity Loan: Steps to Apply
To apply for a home equity loan, follow these steps:
- Figure out how much you need — and can realistically afford — to borrow based on your home equity, financial circumstances and the purpose of the loan.
- Shop around and compare lenders. Consider factors like interest rates, fees, terms and the lender’s reputation when selecting a lender.
- Gather necessary documentation. Similar to applying for a mortgage, you’ll be required to provide all essential documents to qualify for the loan, such as:
- Income documentation to support stated income
- W-2 wage earners: W-2s and pay stubs
- Self-employed: Two years of tax returns (business/personal or both)
- Bank statements
- Complete the lender’s application accurately and completely.
- The lender will review your application and documents, assess your creditworthiness and verify all information. Keep in mind that lenders and loan types may have varying qualification criteria and documentation requirements.
- If conditionally approved, you’ll receive a loan estimate detailing the terms and costs. Once you receive your final approval, you'll have an opportunity to review a Closing Disclosure with the final loan terms. Review all documents carefully, ask questions if needed and sign the paperwork.
Home Equity Loan Alternatives
While a home equity loan is a popular choice for leveraging home equity, it isn’t the only option. A cash-out refinance and a home equity line of credit (HELOC) are two alternatives. Here’s how they compare with a traditional home equity loan.
The Differences Between a Home Equity Loan and Cash-Out Refinance
A home equity loan is a second loan on top of your existing mortgage. You receive a one-time sum of cash upfront and make separate monthly payments on both loans. You would have two loans, and therefore two payments to make every month.
A cash-out refinance involves replacing your current mortgage with a larger one, allowing you to pocket the difference in cash. A cash-out refinance can be advantageous if you require substantial funds while seeking a fixed interest rate or better loan term. With this option, you'll have a single new loan and one monthly payment.
The Differences Between a Home Equity Line of Credit (HELOC) and a Home Equity Loan
Like a home equity loan, a HELOC also uses the equity in your home without touching your first mortgage. The difference between the two is that a home equity loan is a one-time fixed disbursement of funds lent to you for a set term for which payments are spread over the life of the loan.
A HELOC, on the other hand, acts like a credit card and has a revolving credit line. Here’s how it works:
- You can withdraw money up to your credit limit as needed, during what’s called the draw period.
- During the draw period, you usually make interest-only payments.
- After the draw period ends, payments include both principal and interest, and are spread out over the remaining loan term. Keep in mind that during this stage your payment can increase pretty substantially with the addition of principal payments.
- Your rate on a HELOC is typically a variable rate, subject to the fluctuations of the market.
Using and Managing Your Home Equity Loan
Once you receive your home equity loan, be sure to manage it effectively:
Pay on time. Late payments can impact your credit score and may result in fees. Consider setting up automatic payments from your bank account.
Use funds wisely. Try to use your loan proceeds as planned and avoid spending it on unnecessary purchases.
Consider making extra payments. If it fits your budget, making additional payments toward your loan’s principal can help you pay off the loan faster and save on interest.
Maintain good records. Keep your loan documents and payment records organized.
Communicate with your lender. If you encounter any issues repaying your loan, be upfront with your lender. Contact them promptly to discuss potential options.
Home Equity FAQs
How Is Home Equity Calculated?
Your home's equity is the difference between your home's current value and your mortgage's outstanding balance. Use our home value estimator calculator to get an instant estimate of your home’s value.
How Can I Build Home Equity?
Every payment you make toward your loan’s principal balance is helping build equity. You can build home equity faster by increasing your monthly payments — just be sure your extra payments are going toward your principal. If you’re thinking about refinancing to lower your rate, for instance, consider refinancing to a shorter term to build equity faster. You can also wait for your home to appreciate over time or make a home improvement that increases your property’s value. Not all options will be suitable for everyone’s financial situation. For example, while refinancing to a shorter term will help you build equity faster, your monthly payment will likely be larger. Also, unless you are paying out of pocket for any associated costs for a refinance, you may actually be taking away from your equity if there is an increase in principal balance on the home.
What Can Home Equity Loans, Cash-Out Refinance or HELOCs Be Used For?
You can use the funds for almost anything you can think of. Some common reasons people take out a home equity loan or cash-out refinance include:
- Covering unplanned expenses
- Paying for significant home renovations
- Consolidating high-interest debt into one low fixed-rate payment
What Are the Tax Benefits of a Home Equity Loan?
You might be able to deduct interest on a home equity loan if your total mortgage debt is $750,000 or less, you itemize deductions and the loan is used for major home improvements. It's always best to consult a tax professional for specific advice.
How Much Can I Borrow?
The amount you can borrow depends on several factors, including your home’s value, your creditworthiness and your combined loan-to-value ratio, which compares your total debt on your home to its appraised value. Remember that even if a lender approves you for a particular loan amount, you’ll want to consider your ability to comfortably repay the loan before taking on additional debt.
Finding the Option That’s Right for You
A home equity loan may be the perfect solution if you need immediate access to a lump sum of cash, prefer the stability of fixed interest rates and predictable monthly payments — and you don’t want to touch your current mortgage. While cash-out refinancing or other loans can also be viable options, a home equity loan has its own unique benefits.
See how a home equity loan could fit your financial needs, and then contact a Pennymac Loan Expert to get started. We're here to help you make informed decisions about unlocking your home’s potential.
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Meet Our Contributing Editors
Bradley Thompson and Afton Lambert are Contributing Editors for Pennymac’s consumer content and are exemplary leaders within the mortgage industry space. Both experts take pride in helping our customers achieve and sustain their aspirations of home.
For over 13 years, Bradley has achieved success as a high performer in various leadership roles including consumer direct sales and mortgage fulfillment positions.
With over 10 years of mortgage experience, Afton started her career as a top performing Loan Officer, before transitioning into her leadership role, where she has recruited, hired and trained Loan Officers.
