How Does a Home Equity Loan Affect Your Mortgage?

A home equity loan is a way for homeowners to access the equity they have built up in their home. With a home equity loan, you are essentially taking out a second mortgage on your property and using your home as collateral. 

This can allow you to get a large sum of cash relatively quickly and easily. However, a home equity loan also comes with risks, as you are putting your home on the line. If you already have an existing mortgage, you may be wondering how getting a home equity loan could impact it.

A home equity loan, essentially a second mortgage, can impact your existing mortgage by increasing your monthly payments and total interest costs due to higher rates. It can lower your credit score, raise your debt-to-income ratio, and heighten foreclosure risk if you default. If you sell your home, both loans must be repaid in full.

In this article, we will explain what a home equity loan is, how it works, and the various ways it can affect your current mortgage if you choose to take one out. We will look at the potential effects on your monthly payments, interest rates, credit score, debt-to-income ratio, and foreclosure risk. 

We’ll also discuss when you may want to consider a home equity loan, what alternatives exist, and weigh the overall pros and cons. Finally, we’ll provide guidance on how to apply for a home equity loan if you have a mortgage, whether you can refinance with one, and what happens if you sell your home.

What Is a Home Equity Loan?

A home equity loan is a type of loan that allows homeowners to borrow against the equity they have accumulated in their home. Equity represents the current market value of your home minus any outstanding mortgage debt still owed on it. 

As you pay down your mortgage loan over time and as your property value increases, you build equity in your home. With a home equity loan, you can tap into this equity and receive a lump sum of cash in return. The loan amountyou can qualify for depends on how much equity you have.

Home equity loans are also known as second mortgages because you use your home as collateral just like with your first mortgage loan. The home equity loan becomes a lien against your property. You will need to repay the loan plus interest over a set repayment term, usually 5-30 years.

How Does a Home Equity Loan Work?

To obtain a home equity loan, you apply with a lender and go through an application and underwriting process. The lender will review your credit report, debt, income, assets, and other financial information to determine if you qualify and how much you can borrow. 

This involves looking at your credit score, debt-to-income ratio, loan-to-value ratio, and overall ability to afford the monthly payments. If approved, the lender will extend you the loan amount and you will receive the funds in a lump-sum.

With a home equity loan, you will have fixed interest rates and fixed monthly payments over the loan repayment term. The loan is secured by your home, meaning if you default the lender can seize your home through foreclosure. You cannot access additional funds beyond the original loan amount.

How Can a Home Equity Loan Affect Your Mortgage?

If you already have an existing mortgage, taking out a home equity loan can impact it in a few key ways:

1. Impact on Monthly Payments

A home equity loan will add an additional monthly payment on top of your existing mortgage payment. This increases your total monthly housing costs owed each month.

You will need to budget for this increased expense and ensure you can truly afford the higher payment amount. Defaulting on either loan could put your home at risk.

2. Impact on Interest Rates

With a home equity loan, you are likely to get a higher interest rate compared to your first mortgage. This is because second mortgages and junior liens are seen as higher risk.

So even if your original mortgage rate is low, your home equity loan rate will be higher, raising your total interest costs.

3. Impact on Credit Score

Applying for and taking on a home equity loan can lower your credit score temporarily. Too many loan applications in a short timeframe can deduct points.

Taking on more debt also increases your credit utilization ratio. A lower score makes refinancing your first mortgage more challenging.

4. Impact on Debt-to-Income Ratio

Lenders look at your total monthly debt payments divided by your gross monthly income to calculate your debt-to-income ratio. 

A home equity loan payment increases your debt, which in turn increases your DTI. A higher DTI can negatively impact your ability to qualify for future loans or refinancing.

5. Risk of Foreclosure

If you fall behind on your home equity loan payments, the lender can foreclose on your home after a period of delinquency, just like with your mortgage. This can result in you losing your house.

Be cautious taking on more debt against your property than you can realistically manage. Foreclosure will severely damage your credit as well.

When Should You Consider a Home Equity Loan?

Given the potential drawbacks, you may be wondering under what circumstances should you consider tapping home equity. Here are some of the more common scenarios:

• To pay off higher interest, non-deductible debt like credit cards or personal loans
• To finance major home improvements and renovations
• For unexpected emergency expenses like medical bills
• To consolidate other debts into one monthly payment 
• To access cash for a major life event like college tuition
• To invest in something with expected higher returns than the loan cost

However, you need sufficient equity, strong credit, and the ability to handle the higher monthly payments for a home equity loan to make financial sense. Work through the numbers carefully before deciding.

What Are the Alternatives to a Home Equity Loan?

If you have concerns about how a home equity loan could affect your mortgage, you may want to explore some alternatives like:

• Home equity line of credit (HELOC) – Provides revolving access to funds more flexibly
• Cash-out mortgage refinance – Converts equity into lower rate primary mortgage
• Personal loan – Unsecured installment loan with fixed rates and payments
• Using savings – Pay cash from existing savings accounts if possible 
• Credit cards – Can access funds quickly but higher rates than a home equity loan

Compare all options completely to make the most informed borrowing decision based on your situation. 

What Are the Pros and Cons of Taking Out a Home Equity Loan?

Weighing the potential advantages and disadvantages of a home equity loan is important.

As you can see, there are reasonable justifications for utilizing home equity financing, but also many aspects to research and consider before moving forward.

How to Apply for a Home Equity Loan While Having an Existing Mortgage

If you decide a home equity loan is your best course of action, here are the steps to apply for one if you already have a mortgage:

1. Check your credit score and reports so there are no surprises. 
2. Research current home equity rates and terms from multiple lenders.
3. Calculate your monthly payments at different loan amounts to assess affordability.
4. Gather all required financial documents for the application.
5. Complete a home equity loan application and submit to the lender. 
6. Be prepared to pay for an appraisal to confirm home value.
7. Expect the lender to reassess your qualification criteria.
8. Wait for loan approval decision and then move forward with closing process.

Having an established history of making timely mortgage payments will be extremely helpful during the underwriting process when applying for a home equity loan.

Can You Refinance Your Mortgage with a Home Equity Loan?

While they are separate loan products, you can utilize a home equity loan to refinance or pay off your existing mortgage under certain conditions:

• You must qualify for the home equity loan on its own merits 
• The loan amount must be large enough to satisfy the mortgage payoff 
• You will end up with higher payments on a shorter repayment term
• It consolidates balances but you lose any low first mortgage rate 
• Refinancing costs must be factored in as well

For most homeowners, a cash-out mortgage refinance is a better option if your goal is to refinance and tap equity at the same time. You end up with just one loan and can get a lower primary mortgage rate.

What Happens If You Sell Your House With a Home Equity Loan?

If you sell your home while you have an open home equity loan, the loan must be fully repaid immediately along with your first mortgage, typically at closing. Any sales proceeds get distributed first to the primary lender until that loan is paid off.

After satisfying the first mortgage, remaining proceeds then go to repaying your home equity loan balance. You cannot sell the house without first paying off those liens from the sale funds. If proceeds fall short, you would need to provide additional money to cover both loan balances.

Conclusion

Tapping into your accumulated home equity can provide access to funds to help finance major purchases, projects, or debt consolidations. However, it does carry risk and can negatively affect your mortgage. Carefully weighing the pros and cons, assessing your budget, and researching alternatives is crucial before taking out a home equity loan with your house already mortgaged.

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