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5 Steps to Getting a Home-Equity Loan

Author: Ethan Harris

In the market for a home-equity loan but don't know how to get one? We're here to serve, with a step-by-step guide on how to do it.

1. Figure Out What You Need

First, let's identify exactly what it is you're after. While it's become a generic term for anything that uses your residence as collateral to obtain financing, an actual home-equity loan is a fixed-interest-rate loan for a defined period of time – similar to a fixed-rate mortgage. If you need a lump sum of money right now – for consolidating debt, paying off loans or credit cards or doing a large-scale repair on your house – a true home-equity loan is probably your best choice.

In contrast, a home equity line of credit (HELOC) works more like a credit card. You have a set credit limit that you can draw against. Often, that's over a certain period of time, though some lines of credit have no time limit. Other options actually have a debit card attached to them. HELOCs usually come with variable interest rates. Having a line of credit allows you to borrow only what you need at the moment rather than receive a lump-sum payment.

For more details on the two, see Home-Equity Loan vs. HELOC: The Difference.

2. Shop Around

Because home-equity loans don't involve as large sums as mortgages, it's easier to compare terms and interest rates. There are plenty of websites that compare both types of loans from multiple lenders. When looking, "don't focus solely on large banks, but instead consider a loan with your local credit union," recommends Real Estate and Relocation Expert Clair Jones. Credit unions sometimes offer better interest rates and more personalized account service if you're willing to deal with a slower application processing time.

As with a mortgage, you can ask for a good faith estimate. But before you do, make your own honest estimate of your finances. Casey Fleming, mortgage advisor at C2 Financial Corporation and author of The Loan Guide: How to Get the Best Possible Mortgage, says, You should have a good sense of where your credit and home value are before applying, in order to save money. Especially on the appraisal [of your home], which is a major expense. If your appraisal comes in too low to support the loan, the money is already spent – and there are no refunds for not qualifying.

3. Apply

When you make your application, one of the first things a lender will do is pull your credit report. If you have a credit score of 680 or better, you will get a more favorable rate and terms," Arvin Sahakian, vice-president of the home-loan search tool BeSmartee says. "We have so many lenders in this nation that it's difficult to not be able to get a loan. However, your primary goal is to do so at the lowest possible interest rate; otherwise [the loan] can turn on you and put you into a bad financial position.

One of the best ways to do this is to go online, compare rates and, once you find the best for you, call that company and simply apply over the phone, advises Chip Poli, owner of Poli Mortgage in Canton, Mass. If you are planning on scaling back your hours at work or retiring, make sure you apply for the home-equity loan first," Jones adds. "Lenders typically evaluate loan applicants based on their annual income and overall cash flow, so it can be really hard for retirees and part-time workers to get approved.

4. Assemble Your Documents

Just because it's for a smaller amount of money doesn't mean that you won't go through a grueling application process. According to Sahakian, in addition to providing proof of ownership and equity availability, you will need pay stubs for at least the past month, two years of tax returns, three to six months of bank statements, proof of identity and possibly other documentation.

5. Understand the Terms

If you qualify for the loan, be sure you comprehend how it works. Traditional home-equity loans have a repayment term, just like regular mortgages. You make regular, fixed payments covering both principal and interest. That's pretty straightforward.

HELOCs, however, are more complex. They have a draw period – often as much as a decade long – during which you can use the money for whatever you would like. Payments represent only interest during this time. After the draw period, you enter the repayment period. Since these payments involve both loan interest and principal, they will be higher. By the end of this period, you have to have paid off the entire loan, regardless of the current value of your home. Since you don't know what real estate markets or interest rates will do over an extended period of years, you may be making high payments on a home whose value has dropped. In extreme cases, you run the risk of being underwater on your loan.

Home equity lines of credit are a really hot topic right now because they have a 10-year draw period. And if you go back 10 years, it was the time when it was really the height of the market, " Kathy Passman, vice-president of consumer lending at 1st Mariner Bank says. "We are seeing people who are dealing with payment shock: Maybe the equity isn't there.

The Bottom Line

Before doing something that puts your house in hock (or deeper in hock), weigh all of your options. The way you use your loan or line of credit is completely up to you (see Using Home-Equity Loans For Debt Consolidation), but many financial experts advise only using them for home-related purposes. If the loan will finance a want rather than a need, consider saving for it and purchasing later rather than financing the purchase now.

Says Fleming: In my experience, in most cases clients are better off either not taking out any loan at all or pulling cash out by refinancing their existing mortgage. For more on this, see Refinancing vs. a Home-Equity Loan: The Difference.

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