Home Equity Loans: A Complete Guide

What Is A Home Equity Loan?

A home equity loan enables you to use the equity you’ve built in your home as collateral to borrow money. Like a primary loan used to buy a house, your home is used as security to protect lenders if you end up defaulting on your loan.

Home equity loans are often called second mortgages because you have another loan payment to make on top of your primary mortgage.

Rocket Mortgage^® is now offering the Home Equity Loan, which is available for primary and secondary homes.¹ We'll speak about the requirements throughout.

Pros And Cons Of Home Equity Loans

Before you decide to get a home equity loan, you should be aware of the pros and cons. Consider your financial circumstances to determine whether the advantages outweigh the disadvantages.

If a home equity loan doesn’t seem quite right for you, you may still have other options for leveraging your home equity. For example, a cash-out refinance might be a better choice for you. Try exploring your options to figure out what financing path works best for you and your current mortgage.

How To Get A Home Equity Loan

To get a home equity loan, you’ll need to qualify, which means your lender will examine your equity, debt-to-income ratio and credit score. So, if you’re weak in one area, the other two can help boost your qualifications.

Step 1: Get Your Home Appraised

To determine whether you qualify and how much money you can borrow, a lender will have your home appraised. The home appraisal will tell the lender how much your home is worth.

Rocket Mortgage will allow you to borrow up to 90% of your home’s value (with qualifying credit). To figure out the amount you could obtain through a home equity loan, you’d determine your loan-to-value ratio (LTV). To do this, subtract the remaining balance of your primary mortgage from 90% of the appraised value of your home.

For example, if your home is appraised at $400,000 and the remaining balance of your mortgage is $100,000, here’s how you’d calculate the potential home equity loan amount:

$400,000 x 0.9 (90%) = $360,000

$360,000 – $100,000 = $260,000

This means you could secure up to $260,000 if you obtained a home equity loan.

Step 2: Calculate Your Debt-To-Income Ratio

When deciding whether to provide you with the loan, your lender will calculate your debt-to-income ratio (DTI), which shows how your monthly debt payments compare to your monthly income. This calculation helps lenders determine whether you can afford to take on more debt.

To qualify for our Home Equity Loan, your DTI can’t be higher than 50%. To see if you make the cut, you can figure out your DTI using the following equation:

DTI = Total Monthly Debt Payments ∕ Gross Monthly Income

1. Add up all your monthly debt payments, including your primary mortgage, student loans, car loan, minimum credit card payment, alimony and child support.
2. Divide the sum by your gross monthly income, which is the amount of money you earn each month before taxes and deductions.
3. Multiply the result by 100 to find the percentage.

For example, if your total monthly debt is $1,500 (let’s say $950 for your primary mortgage + $300 for your car loan + $250 for your credit card debt), and you earn $5,000 a month before taxes, your DTI would be 30%. In this scenario, your DTI would be low enough to qualify for a home equity loan.

Step 3: Check Your Credit Score

The strength of your credit score also plays a role in determining whether you qualify for a home equity loan. Your credit score is important because it helps lenders understand your credit history. Individuals with higher credit scores often benefit from lower interest rates.

The minimum credit score needed for a home equity loan is generally around 620, but this is lender-dependent. Some lenders might prefer your score be closer to 680. If you want to obtain a home equity loan, a higher credit score will give you more flexibility on terms. For example, higher scores may allow you to access more of your equity.

At Rocket Mortgage, a 680 credit score means you're limited to accessing up to 80% of the equity you have in your home. If your FICO^® Score is a median of 700 or better, you can access up to 85%. Finally, you can borrow up to 90% of your home’s value if your score is 740 or higher.

Remember that these LTV amounts combine both your primary mortgage and your new home equity loan. For example, if you have 45% LTV on your primary mortgage, you can only borrow a further 45% of your home’s value for a total of 90%.

Getting A Home Equity Loan With Bad Credit

Those who have had past credit issues know that it tends to be easier and less costly to obtain a home equity loan than a personal loan. Because home equity loans are secured by your home, they’re less risky for lenders. On the other hand, if you’re unable to keep up with your monthly payments, the lender can foreclose on your home to recoup costs.

If you’ve built up a fair amount of equity in your home and have a low DTI, your chances of obtaining a home equity loan will be higher despite a low credit score. If you find yourself in this situation, your home equity loan will likely come with higher interest rates and fees.

If your finances demonstrate to lenders that you may be unable to repay the money borrowed, you’ll find it more challenging to obtain a home equity loan.

Home Equity Loans Vs. Other Options

Home equity loans are a great tool to help you borrow against your home’s equity. However, you can access the money you’ve built up in your home in other ways. Before you can decide if a home equity loan is the right choice for your needs, you need to understand your options. Here are a few alternatives you can look into.

Cash-Out Refinance

While home equity loans enable you to take out a second mortgage on your property, cash-out refinances replace your primary mortgage. Instead of obtaining a separate loan, the remaining balance of your primary mortgage is paid off and rolled into a new mortgage that has a new term and interest rate.

With a cash-out refinance, you receive funds for the equity in your home, just as you would with a home equity loan. Unlike a home equity loan, you have only one monthly mortgage payment.

If you choose to get a cash-out refinance, you usually can secure a lower interest rate than with a home equity loan. The discrepancy in interest rates has to do with the order in which lenders are paid when defaults and foreclosures occur.

Learn more about the differences between home equity loans and cash-out refinances.

Home Equity Lines Of Credit (HELOCs)

A home equity line of credit is another option for converting your home equity into cash. Like home equity loans, HELOCs are second mortgages. However, instead of providing borrowers with a lump-sum payment, HELOCs pay out more like credit cards. Home equity lines of credit provide you with a predetermined amount of money that you can draw from when necessary.

Unlike home equity loans, HELOCs have variable interest rates, which are similar to adjustable-rate loans. This means your interest rate increases or decreases over the loan term as the market fluctuates, as does your monthly payment, making it difficult to anticipate how much you’ll owe. Rocket Mortgage currently does not offer HELOCs.

When Is A Home Equity Loan The Right Choice?

Home equity loans can be a great loan option for some homeowners. Here are a few situations in which a home equity loan makes the most sense:

• If you need money fast: A home equity loan is a good choice when you need a large amount of money immediately but want to lock in a lower interest rate than you’d find with a credit card or personal loan.
• If you have a strict, fixed budget: Home equity loans can be the right option when you have one specific expense and are aware of the full amount that you’ll need to spend on it.
• If you’re paying off higher-interest debt: They’re also the better choice if you want to use the funds to pay off other debts that have higher interest rates, as you’ll know your rate won’t change.

How To Choose The Best Home Equity Loan

Home Equity Loan FAQs

Home equity loans make accessing the cash you have tied up in your house easy, but you still need to make sure they’re the right fit for your finances. Here are some other frequently asked questions regarding home equity loans to help you make the right decision.

How does a home equity loan differ from a home equity line of credit (HELOC)?

A home equity loan gives you money in a single lump-sum payment. A HELOC allows you to borrow money as needed up to the limit of the line of credit for a predetermined length of time.

Will taking out a home equity loan hurt my credit score?

Any time you open a new loan, like a home equity loan, your credit score may drop slightly. The drop will likely be temporary, and your score may even increase after opening the loan since your total available credit will go up.

What should I look for when applying for a home equity loan?

Look for a lender that offers you a home equity loan with a low interest rate, affordable origination fees, fair repayment terms and monthly payments that fit your budget.

The Bottom Line: A Home Equity Loan Could Be Right For You