What is a home equity loan and how does it work?
If you’re a homeowner in need of cash, tapping into your equity can be a smart way to get it. There are several options for doing this, one of which is taking out a home equity loan. However, it’s important to understand the costs and risks before you borrow.
Here’s what to know about home equity loans and how they work.
What is a home equity loan?
A home equity loan is a type of second mortgage. It allows you to borrow against your home’s equity — which is your ownership stake in the property — and uses your home as collateral.
You can use the funds from a home equity loan for almost any purpose. For example, many homeowners take out a home equity loan to pay for house repairs or renovations. Others use these loans for debt consolidation — to consolidate high-interest debt, like credit cards or personal loans.
How does a home equity loan work?
A home equity loan provides a lump-sum payment, which you’ll pay back — plus interest — in fixed payments over several years. Exact repayment terms vary by lender, but they typically range from five to 30 years.
How much can I borrow with a home equity loan?
How much you can borrow depends on the lender you choose, as well as other factors like your credit score, other debts you have, your income, and more. Generally speaking, though, you can typically borrow up to 80% to 90% of your home’s appraised value, minus any balance you have on your existing mortgage.
Your loan amount is also impacted by your combined loan-to-value (CLTV) ratio, which compares all of the loans secured by your home (including your first mortgage and the desired home equity loan) to your home’s appraised value. Lenders typically have CLTV limits of 85%, though some allow higher ratios.
Home equity loan costs
Home equity loans come with borrowing costs, just as your first mortgage did. There will be closing costs, and you’ll pay interest each month. There can also be penalty fees associated with these loans. Here are the costs to prepare for before you apply:
Home equity loan rates
Home equity loan rates are usually fixed, meaning you’ll have the same interest rate and payment for the entire life of the loan. As with traditional mortgage rates, home equity loan rates also vary by lender. Your credit score, debt-to-income (DTI) ratio, loan amount, and other factors will all play into the rate you qualify for as well. Because home equity loans are secured by collateral, they tend to have lower rates than unsecured options like credit cards and personal loans.
Learn: Secured vs. unsecured loans
Home equity loan closing costs
While the exact closing costs you’ll pay for a home equity loan depend on your lender, location, and other factors, you can typically expect these to range from 3% to 6% of your total loan amount. These costs go toward things like your appraisal, pulling your credit, and originating the loan.
Fees on home equity loans
You’ll pay the majority of your home equity loan fees as part of your closing costs. However, you could run into various penalty fees in some situations later on, depending on your lender. For example, you might be charged a prepayment fee if you pay off your loan too early or a late fee if you submit your monthly payment past the due date.
How do I get a home equity loan?
Many home equity loan lenders allow you to apply online while others might require a phone call with a loan specialist or visit to a local branch. You’ll need to agree to a hard credit check as part of the application process (which can cause a slight but temporary drop in your credit score) as well as submit required paperwork, such as proof of income.
The exact requirements of these loans vary by lender, but you’ll typically have to meet the following standards:
| Criteria | Requirement |
|---|---|
| Maximum DTI ratio | 43% to 50% |
| Minimum credit score | 620 to 660 |
| Minimum equity | 10% to 20% |
| Maximum loan-to-value ratio | 85% or 90% |
Most lenders will also require an appraisal as part of the loan process. This confirms your home’s market value, so the lender knows how much equity you have.
Home equity loan alternatives
If a home equity loan doesn’t seem quite right, there are other ways to tap into your equity as well as unsecured loan options. Here are some of these alternatives to consider:
- Cash-out refinance: This option pays off your current mortgage with a larger one, and you’ll receive the difference as cash. Because you’re getting a new loan, you’ll also get a new rate and term — so be careful if you already have a good rate on your current mortgage.
- Home equity line of credit (HELOC): Like a home equity loan, a HELOC is a type of second mortgage that lets you borrow against your equity. However, instead of receiving a lump sum, you’ll have access to a credit line that you can pull from on an as-needed basis during the draw period — similar to a credit card.
- Personal loan: If you’d prefer not to use your home as collateral, you could consider an unsecured personal loan. You can borrow as little as a few hundred dollars up to $100,000, and you’ll typically have one to seven years (or longer) to pay it off, depending on the lender. Because personal loans usually aren’t backed by collateral, they tend to have higher rates compared to secured options like home equity loans.
Is a home equity loan a good idea?
Whether a home equity loan is a good idea depends on your needs and circumstances. For example, if you need cash and know you can handle the monthly payments, then a home equity loan could be ideal.
However, it’s important to keep the risks in mind. These loans use your home as collateral, which means the lender could foreclose on your house if you fail to make your payments. Always have a plan for making your payments on time, every time, before borrowing against your home equity.
Find out: Is a home equity loan a good idea?
Home equity loan FAQs
This depends on your lender, but you can typically find home equity loans with terms ranging from five to 30 years. While choosing a shorter term means having a higher payment, it can also save you money on interest over time.
You might not be eligible for a home equity loan if you lack sufficient equity or income, have a poor credit score, or have a high DTI ratio.
The biggest negative of a home equity loan is that it uses your home as collateral. This means if you fail to make your payments, the lender can foreclose on your house. You’ll also have to pay closing costs and potentially other fees in some cases, and you’ll have to manage another payment in addition to your original mortgage payment.
It’s only a good idea to borrow from your home equity if you know you can handle the monthly payments the loan will come with. Missing payments could lead to foreclosure and losing your house.
The interest you pay on a home equity loan can be tax-deductible, but only if you use the loan’s funds to buy, build, or substantially improve your house. If the money isn’t used for these purposes, then the interest isn’t tax-deductible under current IRS rules.
