How Does a Home Equity Loan Work?

You too can take advantage of soaring home prices. And no, you don't have to sell your home in order to cash in.

As real estate values rise across the country, a growing number of homeowners are pulling cash out of their homes through home equity loans and home equity lines of credit, or HELOCs.

More than 10 million people will take out a home equity line of credit over the next five years, double the number from 2013 to 2017, a TransUnion study predicts.

Ready to jump on the home equity band wagon? You'll need at least two things: Equity in your home from which to draw on and a decent credit score.

You have equity when the market value of your home is higher than what you owe on your mortgage. A home equity loan or a home equity line of credit allows you to borrow against some of that equity, with your home pledged as collateral.

Here's what you need to consider when deciding whether to apply for a home equity loan or HELOC:

Find Out Your Credit Score

Before you go to the trouble of filling out a loan application, you need to get a handle on whether your credit scores are high enough to make you a viable candidate. Wells Fargo offers up this advice for homeowners seeking a home equity loan or line of credit.

You'll need an "excellent" credit sore of 760 and up to get the best rates, according to Wells Fargo. A score of 700 to 759 lands you in the "good" pile - you'll like get a loan but maybe not the best rates. It goes downhill from there, with 621 to 699 considered "fair," meaning "you may have difficulty obtaining credit, and likely pay higher rates for it," with 620 and below classified as "poor."

How Much Debt Do You Have?

Consolidating credit card and other debt through the use of a home equity line of credit is a popular move for many homeowners. But if you have too much debt, you might not be eligible for the loan in the first place. In addition to a good credit score, most banks will be inclined to say thumbs down if your debt is already chewing more than 43% of your income.

Calculate Your Equity

Once you have figured out that you stand a decent chance to get a home equity loan or line of credit, you'll want to start crunching some numbers. You have equity in your home if its market value is higher than the balance on your mortgage. Since that's a prerequisite, you'll want to see if you have enough equity in your home to go to the trouble of applying for a loan. Most banks won't lend more than 80% of the value of your home, minus the current mortgage amount.

Calculating this figure is a two-step process. Let's say you bought your home a decade ago and it's now worth $500,000. Your mortgage is $300,000, so the good news is that you have equity. Step one, calculate 80% of the current value of your home, or .80 x $500,000. Take the answer, $400,000, and subtract from it your mortgage amount, $320,000, for an answer of $80,000. That's how much home equity you should be able to tap through a loan or line of credit.

What Are Your Plans?

There are a whole range of reasons homeowners opt to borrow against the equity in their homes. A recent TransUnion study of borrowers who took out home equity lines of credit, or HELOCs, found that 30% were taking advantage of the loans' generally lower rates to consolidate higher-cost credit card and other debt. Twenty-nine percent were planning to do renovations on their home, 25% were refinancing an existing HELOC, and 9% were using for a down payment on another home. A final 7% were saving the credit line for a "rainy day."

The reason you take out a home equity loan, though, is important. If it's for home improvement purposes, you can deduct the interest off your taxes. But under the new Trump tax law, if you are consolidating other debt, you will no longer get a tax break.

What Type of Home Equity Loan?

You will likely have two choices: A fixed-rate home equity loan or a variable rate home equity line of credit, or HELOC. A home equity loan is basically a second mortgage, in which you take out the total amount you intend to borrow in one lump sum and pay it back every month. The time period is typically 5-15 years.

A home equity line of credit, or HELOC, gives you the ability to borrow up to a certain amount over a 10-year period. Like a credit card, you can simply pay off the interest every month or pay down the principal as well, depending on your financial needs at the time.

Consider the Risk

No financial transaction is completely without risk and taking out a loan, especially one involving your house, is serious business. There are advantages, for example, to taking out a home equity line or home equity line of credit to pay off credit card debt. A fixed-rate home equity loan or even a HELOC with it variable rate is likely to come with a lower rate than what you are paying on your cards. But unlike the credit card company, which can merely try and wreck your credit record if you can't pay your monthly bill, your lender can foreclose on your house if you default on a home equity loan or HELOC. Second, HELOC rates are variable. While interest rates are still historically low, that may not always be the case, especially as we look five or 10 years out.

Go for it: If you've made it this far, you are ready to start shopping rates. It's a competitive field so you should have lots to pick from, especially if you have good credit and a decent amount of equity in your home. Good luck and happy rate shopping.

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