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Homeowners can take out a home equity loan on a paid-off house the same way they would if they had a mortgage on the property. However, using a paid-off house as collateral for a loan is a move borrowers should consider carefully.
How to get a home equity loan on a paid-off house
When you take out a home equity loan on a paid-off house, you’ll have to check off the same boxes you would for a traditional mortgage. Lenders will make sure your home’s value can support the amount you want to borrow. Additionally, lenders will review your financial information to make sure you can afford the loan.
Here are the steps to using a paid-off house as collateral for a home equity loan.
1. Know where you stand. A paid-for house means you have 100% equity in your home. However, having enough equity is just one requirement you’ll need to meet when you take out a home equity loan on a paid-off house. Lenders typically consider the following factors:
- Ability to repay: To determine your ability to repay, a lender may ask to see your recent tax returns, income history and proof of assets. "Unfortunately, most people pay off their homes when they are nearing retirement, so the lack of income can be a deterrent for lenders," said Jim Pendergast, senior vice president and general manager of altLINE, a division of the Alabama-based Southern Bank Company.
- Credit score: Lenders may have a minimum credit score they look for to approve borrowers for a home equity loan. Additionally, your credit score affects the interest rate on the loan.
- Debt-to-income (DTI) ratio: Your DTI ratio signals how much debt you have in proportion to your income. Generally, lenders look for a DTI ratio below 43% for home equity loans. If you’re carrying a lot of other debt, your lender may not approve the loan.
- Loan-to-value (LTV) ratio: Even if you have 100% equity in your home with a paid-for home, you won’t be able to access all of your home equity. Typically the maximum LTV ratio on home equity loans is 85%; however, some loan types may allow a higher percentage.
2. Apply for a home equity loan. When you borrow against your house, you'll get a competitive interest rate by applying with multiple home equity loan lenders. Consider getting quotes from various types of lenders. For example, you might want to start with a bank or credit union you already have a relationship with. Additionally, consider other local, regional or national banks and online lenders.
3. Compare home equity loans. Each lender you apply to will provide a loan estimate. Review and compare the loans to determine which lender has the best terms. In addition to the interest rate and monthly payment, compare the annual percentage rate (APR), length of the loan, total interest paid and loan fees.
4. Negotiate loan terms. After comparing loans, consider negotiating with the lenders. For example, if Lender A has the lowest interest rate, but you prefer to do business with Lender B, see if Lender B will match or beat the lower rate. When negotiating, be sure that a lender doesn’t change other loan terms to accommodate your request.
5. Close on the loan. After you’ve selected a loan, you’ll move forward with the underwriting process. Your lender may require additional information on the property and your finances. Once the underwriting process is complete, you’ll close on the home equity loan.
Pros and cons of getting a home equity loan on a paid-off house
Using a paid-off house as collateral has both advantages and disadvantages. Consider these pros and cons before taking out a home equity loan.
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.
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.
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.
6 things to consider before using a paid-off house as collateral
When you borrow against a house that is paid off, you’re introducing a financial risk that didn’t exist before. Regardless of the loan product you choose, you’ll be exposing your home to the possibility of foreclosure if you’re unable to afford the payments.
Before taking out a mortgage on a property you own, consider the following to determine if the benefits outweigh the risks:
- How you plan to use the equity. Think about what you’ll do with the money. If the home equity loan or mortgage results in increasing your home’s value, it might be worth taking on the added risks. On the other hand, if you’re tapping into your equity to cover unsecured debt or purchase items that will decrease in value, you may be unnecessarily putting your home at risk.
- How much you plan to borrow. The amount you borrow will determine the size of your monthly payments. If you need to borrow a significant amount, compare the expected monthly payments, interest and loan terms of all your mortgage options.
- How long it will take to pay off the new loan. Think about the loan's term length and whether it makes sense to be in debt that long — especially if you’ve paid off your home after making mortgage payments for several years.
- Whether you can afford the payment. Before using a paid-off house as collateral, make sure the new payment will fit in with your budget and overall financial goals. Will your savings suffer? Will other financial goals have to wait? Think about the answers to these questions before introducing a new payment.
- Whether you’ll qualify for a good interest rate. Your credit history and other financial information affect your mortgage rate on a mortgage or home equity loan. Since the rate determines the overall cost of the mortgage, think about whether it makes sense to borrow at the quoted rate.
- Whether other alternatives are better suited for you. Before taking out a mortgage on a property you own, consider all your options. Would it be better to wait and save up for what you want to finance? Or would other borrowing options that don’t put your home at risk make more sense?