Can I Get a Home Equity Loan on a Paid-Off House?

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Maurie Backman Maurie Backman is a personal finance writer who covers everything from savings to retirement to healthcare. Her articles have appeared broadly on major outlets such as CNBC, MSN, and Yahoo.

When A Cash-Out Refinance Makes Sense

If your home value has climbed or you’ve built up equity over time by making payments, a cash-out refinance might make sense for you.

Cash-out refinancing is a very low-interest way to borrow the money you need for home improvements, tuition, debt consolidation or other expenses. If you have big expenses that you need to borrow money for, a cash-out refinance can be a great way to cover those expenses while paying little in interest.

Interest rates for a second home

If you’re using cash from your equity to buy another home, make sure you understand how interest rates work on a vacation home, second home, and investment property.

Since the new home won’t be your primary residence, you can expect a slightly higher mortgage rate. This rate increase protects the lender because these properties have a higher risk of default.

Mortgage lenders know that in the event of financial hardship, homeowners prioritize paying the mortgage on their primary home before a second home or investment property.

But although you’ll pay a higher rate when buying a second home, shopping around and comparing loans can help you save. To see the impact of higher mortgage rates, you can experiment with a mortgage calculator.

Whether you’re purchasing another home, or getting a cash-out refi, home equity loan, or home equity line of credit, make sure you request rate quotes from at least three mortgage lenders.

Compare rates, but also compare upfront fees.

If You Have Poor Credit

Home equity loans can be easier to qualify for if you have bad credit, because lenders have a way to manage their risk when your home is securing the loan. Nevertheless, approval is not guaranteed.

Collateral helps, but lendershave to be careful not to lend too much, or they can risk significant losses. It was extremely easy to get approved for first and second mortgages before 2007, but things changed after the housing crisis. Lenders are now evaluating loan applications more carefully.

All mortgage loans typically require extensive documentation, and home equity loans are only approved if you can demonstrate an ability to repay. Lenders are required by law to verify your finances, and you'll have to provide proof of income, access to tax records, and more. The same legal requirement doesn't exist for HELOCs, but you're still very likely to be asked for the same kind of information.

Your credit score directly affects the interest rate you'll pay. The lower your score, the higher your interest rate is likely to be.

Next steps

If you’re considering borrowing equity from your home, your first step is to approximate how much your home is worth. Then, take your existing mortgage balance and divide by your home’s value to figure out if you are eligible.

Develop a plan that addresses why you want to take equity out of your house and how and when you’ll pay it back. It’s best if you only take equity out of your home for a specific purpose that has a positive financial payback. This could be anything from consolidating other debts with a lower interest rate to improving your home’s value through a major home improvement project.

Finally, determine whether a home equity loan, home equity line of credit or cash-out refinance is best for you, and then shop around with a few lenders to get the process started. Check out Bankrate’s reviews of home equity lenders to help in your research process.

Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) provides the most flexibility. This type of loan is a second mortgage with a revolving balance: You borrow only what you need, pay it off, then borrow again. It works in the same manner as a credit card but with significantly lower interest rates. Your payment is based on the amount of credit that you use rather than the available loan amount. Most lines of credit come with a checkbook or a debit card to provide easy access to funds.

Unlike the other two forms of secondary home loans, HELOCs usually come with no closing costs. Also, HELOCs have adjustable rates that vary with the prime rate, meaning that your rate could rise or fall over the life of the loan. HELOC rates are often discounted at the beginning of the loan term and then increase after six to 12 months.

HELOCs are typically divided into two stages: the draw period and the repayment period. The draw period is typically five to 10 years, during which time you can withdraw money up to your line of credit and make interest-only payments. During the repayment period, the final amount that you’ve withdrawn becomes a loan to be repaid with interest, and within a specified time period (often 10 to 20 years). During this time, you can no longer draw against the account.

Repayment Terms

Repayment terms depend on the type of loan you get. You'll typically make fixed monthly payments on a lump-sum home equity loan until the loan is paid off. With a HELOC, you might be able to make small, interest-only payments for several years during your “draw period" before the larger, amortizing payments kick in. Draw periods might last 10 years or so. You’ll start making regular amortizing payments to pay off the debt after the draw period ends.

The bottom line on borrowing against your home

Taking out a home equity loan or HELOC is a good way to access what could be a large amount of money without having to jump through a lot of hoops. It’s certainly better than charging expenses on a credit card and paying exorbitant amounts of interest that not only cost you money, but drag down your credit score in the process.

That said, before you take out a home equity loan or a HELOC, make sure you know what you’re getting into. Read the fine print on your loan or HELOC contract so you’re not hit with any surprise costs or fees, and don’t borrow more than you can reasonably afford to pay back.

Finally, realize that a home equity loan or HELOC shouldn’t take the place of a true emergency fund. The beauty of having money in the bank is that it’s yours to use when and how you want to, and if you withdraw from savings in a pinch, you’re not on the hook for interest while you work to replenish your bank account. Just as importantly, you don’t put your most valuable asset — your home — on the line in an effort to drum up some cash. 

How you receive your funds

Cash-out refinance gives you a lump sum when you close your refinance loan. The loan proceeds are first used to pay off your existing mortgage(s), including closing costs and any prepaid items (for example real estate taxes or homeowners insurance); any remaining funds are yours to use as you wish.

Home equity line of credit (HELOC) lets you withdraw from your available line of credit as needed during your draw period, typically 10 years. During this time, you’ll make monthly payments that include principal and interest. After the draw period ends, the repayment period begins: You’re no longer able to withdraw your funds and you continue repayment. You have 20 years to repay the outstanding balance.

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How to Apply for a Home Equity Loan After Your Home is Paid Off

You can apply for a home equity loan or HELOC by visiting a local lender’s branch office or filling out an online application. You’ll need to provide the same types of documentation that you do when you apply for a mortgage.

Along with the information on your application and your credit report, the lender will want to see your pay stubs, W-2 forms, documentation of other sources of income, and the most recent monthly statements on all outstanding debts. The lender will also want to obtain an appraisal report in order to determine the current market value of the property, as well as at least 2 years of tax returns.

The lender will evaluate your credit history and total outstanding debt payments as part of the underwriting process to see if you meet the requirements. This is where it will help you to have paid off your home.

You established good borrowing behavior by paying off the debt, you no longer have that debt adding to your overall debt calculation, and you will be able to access the maximum amount of money that could be available based on the current market value of your property.

Here’s How it Works

This example shows how a lender evaluating an application for a home equity loan uses a loan-to-value calculation called a combined loan-to-value (CLTV) ratio. This ratio adds the combined amount of outstanding debt from the mortgage and home equity loan and then divides that amount by the total property value:

CLTV = (outstanding balance on mortgage + outstanding balance on home equity loan) / home value

Or

CLTV x home value = total outstanding balance on mortgage and home equity loan

Lenders generally don’t want the CLTV to exceed 85%. So, if you have a home value of $250,000 and have paid off your home, you could potentially borrow up to $212,500 with a home equity loan.

0.85 x $250,000 = $212,500

On the other hand, consider a situation where you have not paid off your home. Assume you have an outstanding mortgage balance of $150,000 on that $250,000 home. The calculation above showing the maximum dollar amount of your combined loans has not changed. You can still have a combined outstanding balance of $212,500. Now, however, that has to include your mortgage balance of $150,000. What’s left over is the maximum dollar amount you can borrow in a home equity loan: $62,500.

$212,500 – $150,000 = $62,500

If you’ve been thinking to yourself, “My house is paid off, can I get a loan?” you can now see why having no mortgage can help you qualify.

However, it is important to mention that even though there is an allowable amount to borrow, you should not borrow more than is needed for the purpose of the loan. You should also be aware of closing costs since most home equity loans and HELOCs have these.

The Three-Day Cancellation Rule

What is the Three-Day Cancellation Rule?

This federal rule says you have three business days, including Saturdays but NOT Sundays, to reconsider a signed credit agreement that secures your principal residence and cancel the deal without penalty. The Three-Day Cancellation Rule applies to many home equity loans (and also applies to home equity lines of credit, see below).

You can cancel for any reason, but only if you’re using your main residence as collateral. That could be a house, condominium, mobile home, or houseboat. The right to cancel doesn’t apply to a vacation or second home.

Under the Rule, how long do I have to cancel?

You have until midnight of the third business day to cancel your loan. Day one begins after all these things have happened

  • you sign the loan at closing, and
  • you get a Truth in Lending disclosure form with key information about the credit contract, including the APR, finance charge, amount financed, and payment schedule, and
  • you get two copies of a Truth in Lending notice explaining your right to cancel

If you didn’t get the disclosure form or the two copies of the notice — or if the disclosure or notice was incorrect — you may have up to three years to cancel.

How do I determine the third business day?

You may get the disclosure and two copies of the right to cancel notice at your closing. In that case, Day One begins after the closing. But if you get the disclosure form and the two copies of the notice before or after the closing, Day One begins on when the last of the three things happened. So if the closing happens on a Friday, and if that was the last thing to happen, you have until midnight on Tuesday to cancel. But if you received your Truth in Lending disclosure form on Thursday and you closed on Friday, but didn’t receive two copies of the right to cancel notice until Saturday, you have until midnight on Wednesday to cancel. For cancellation purposes, business days include Saturdays but not Sundays or legal public holidays.

During this three-day waiting period, the lender cannot directly or through another person take action related to the loan. The lender can’t deliver the money for the loan (other than in escrow), or begin performing services. If you’re getting a home improvement loan, the contractor can’t deliver any materials or start work. The lender can begin to accrue finance charges during the delay period.

What steps do I take if I want to cancel?

You must inform the lender in writing that you want to cancel:

  • You must mail or deliver your written notice before midnight of the third business day.
  • You may not cancel by phone or in a face-to-face conversation with the lender.

Will I owe any money on the contract if I cancel during the three-day waiting period?

If you cancel the contract, the security interest on your home is no longer valid, your home is no longer collateral and can’t be used to pay the lender. You don’t have to pay anything, and any amounts you paid must be refunded, including the finance charge and other charges, such as application fees, appraisal fees or title search fees, whether paid to the lender or to another company that is part of the credit transaction. The lender has 20 days after receiving your notice to return all money or property you paid as part of the transaction and to release their interest in your home as collateral, which they must do even though the security interest is no longer valid from the day the lender received your cancellation notice.

If you got money or property from the lender, you can keep it until the lender shows that your home is no longer being used as collateral and returns any money you’ve paid. Then, you must offer to return the lender’s money or property. If the lender doesn’t claim the money or property within 20 days, you can keep it.

Under the Rule, can I waive my right to cancel the contract?

If you have a personal financial emergency — like damage to your home from a storm or other natural disaster — you can waive your right to cancel. That eliminates the three-day waiting period so you can get the money sooner. To waive your right:

  • You must give the lender a written statement describing the emergency and stating that you are waiving your right to cancel.
  • The statement must be dated and signed by you and anyone else who also owns the home.

Your right to cancel gives you extra time to think about putting your home up as collateral for the financing to help you avoid losing your home to foreclosure. If you have a personal financial emergency, you can waive this right, but be sure that’s what you want before you waive it.

Are there exceptions to the Three Day Cancellation Rule?

Yes, the federal rule doesn’t apply in all situations when you are using your home for collateral. Exceptions include when

  • you apply for a loan to buy or to initially build your main residence
  • you refinance your mortgage with the same lender who holds your loan and you don’t borrow more funds (but if you borrowed additional money the rule applies and you can cancel)
  • a state agency is the lender for a loan

In these situations, you may have other cancellation rights under state or local law.

What Is A Home Equity Loan?

A home equity loan is a second loan that’s separate from your mortgage and allows you to borrow against the equity in your home.

Unlike a cash-out refinance, a home equity loan doesn’t replace the mortgage you currently have. Instead, it’s a second mortgage with a separate payment. For this reason, home equity loans tend to have higher interest rates than first mortgages. Rocket Mortgage® doesn’t offer home equity loans at this time.

How It Works

Because a home equity loan is an entirely separate loan from your mortgage, none of the loan terms for your original mortgage will change. Once the home equity loan closes, you’ll receive a lump sum payment from your lender, which you’ll be expected to repay – usually at a fixed rate.

Restrictions On Your Loan

Lenders will rarely allow you to borrow 100% of your equity for a home equity loan. The maximum amount you can borrow varies depending on the lender, but it’s usually between 75% and 90% of the value of the home. As with a cash-out refi, the amount you can borrow will also depend on factors like your credit score, debt-to-income ratio (DTI) and loan-to-value ratio (LTV).

Can you sell your house if you have a home equity loan?

You don’t have to pay off your home equity loan or other liens to list your home for sale. At the sale’s closing, creditors holding liens on your home’s title will be paid off from the proceeds of the sale.

Other ways to borrow against your house

Taking out a home equity loan on a paid-off house isn’t the only option for accessing your home equity. Here are a few other ways to borrow against a house you own.

Cash-out refinance

If you want to take out a mortgage on a paid-off home, you can do so with a cash-out refinance. This option allows you to refinance the same way you would if you had a mortgage.

When refinancing a paid-off home, you’ll decide how much you want to borrow, up to the loan limit your lender allows. Cash-out refinance loans can be a less expensive option than home equity loans because they have lower interest rates than home equity products. However, closing costs can be higher because the process of refinancing a paid off-home is similar to buying a house.

Home equity line of credit

A home equity line of credit (HELOC) is another way to borrow against a house. A HELOC works similar to taking out a home equity loan, but with a few differences.

Instead of receiving the loan proceeds upfront in one lump sum, you’ll have a line of credit to use as needed, similar to a credit card. You’ll have access to the line of credit during what’s called the draw period and then repay it during the repayment period. Additionally, HELOCs typically have variable interest rates, making them riskier than home equity loans. However, they have lower interest rates than home equity loans, as well as personal loans and credit cards, because you’re using a paid-off house as collateral.

Reverse mortgage

Homeowners ages 62 and older can take out a mortgage on a paid-for home with a home equity conversion mortgage (HECM), the most common type of reverse mortgage. Instead of making mortgage payments and decreasing your loan balance, your lender makes payments to you on a reverse mortgage and your loan balance grows over time.

Borrowers can choose to receive reverse mortgage proceeds in a lump sum, a line of credit or monthly payments. These options allow homeowners to use the loan as they wish, which might include supplementing income, making home improvements or funding large purchases. Keep in mind that with a reverse mortgage, you’ll be eating into your home equity as time progresses. And when you sell the home or no longer live in it, the loan becomes due.

The Bottom Line

Many homeowners believe that selling their house is the easiest and most convenient way to get a needed cash influx. Even homeowners who own other types of assets may find this strategy appealing if they want to avoid selling taxable holdings that would trigger capital gains taxes or withdrawal penalties on early individual retirement account (IRA) or retirement plan distributions. However, accessing your home equity can be a smart way to borrow—without having to sell your home, take out expensive personal loans, or rack up credit card debt.

Home equity debt is not a good way to fund recreational expenses or routine monthly bills. However, it can be a real lifesaver for anyone saddled with unexpected financial challenges. Home equity debt can also be a good way to invest in the future. The key is to make sure that you borrow at the lowest possible interest rate—and keep in mind that borrowers who do not repay these loans can lose their homes in foreclosure.

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