How Does a Home Equity Loan Work?

What Is a Home Equity Loan?

As the name implies, a home equity loan is secured by the equity in your home. Equity is your home’s market value minus your mortgage balance. Although it’s sometimes called a second mortgage, a home equity loan doesn’t affect your mortgage. Your mortgage interest rate, term and payments stay the same—you’ll just have another monthly payment.

Home equity loans work like this: If you paid $225,000 for your home, owe $125,000 on your mortgage, and your home is now worth $425,000, you have $300,000 in equity. You can typically borrow 75% to 85% of your home’s equity, so with $300,000 in equity, you could borrow $225,000 to $255,000.

The interest rate on your home equity loans will be fixed, which means your monthly payments won’t change over the loan term (typically from five to 30 years). You receive the loan in a lump sum and repay it in monthly installments.

What Can You Use a Home Equity Loan For?

A home equity loan can be used for nearly any purpose, including:

• Medical bills
• Home or car repairs
• Legal expenses
• Larger-than-expected tax bills
• A child’s wedding
• Home improvements

Home equity loans can also be used to pay off high-interest debt such as credit cards, but this isn’t always an ideal move since it will convert your unsecured credit card debt to debt that’s secured by your home. It could, however, help you reduce your overall interest costs as long as you avoid running up high card balances again.

Home Equity Loan Requirements

To get a home equity loan, you’ll generally need to meet these requirements:

• FICO Score of 680 or more: Lenders usually require a FICO Score of at least 680 for a home equity loan. However, some prefer a score of 720 or higher. Others may give you a home equity loan with a FICO Score below 680 if you have lots of equity, a sizable income or a low debt-to-income ratio (DTI).
• Solid payment history: Lenders generally review your credit report to see if you have a history of making on-time payments for a variety of credit accounts.
• Proof of income: Lenders check your pay stubs and W-2 forms for evidence that your income is sufficient to cover the loan payments.
• Debt-to-income ratio of 43% or less: Your DTI is the percentage of your gross monthly income needed to pay your debts. A DTI of 44% or more could make it hard to get a home equity loan.
• Sufficient equity: Most lenders require your equity to equal at least 15% to 20% of the home’s value.
• Proof of homeowners insurance: Your home is collateral for the loan; lenders generally require home insurance to safeguard it.

Pros and Cons of a Home Equity Loan

Weigh both advantages and disadvantages when considering a home equity loan.

Pros of Home Equity Loans

• Can allow you to borrow a large sum: A home equity loan often lets you borrow more money than other financing options, including personal loans.
• Could mean a tax break: Use a home equity loan for substantial improvements that add to your home’s value, extend its useful life or adapt it for new uses, and the interest paid on the loan may be deductible come tax time.
• Lower interest rates: Since they’re secured by your home, home equity loans generally have lower interest rates than personal loans or credit cards.
• Fixed interest rates: The interest rate won’t change during the loan term, so you know exactly how much borrowing will cost.
• Fixed monthly payments: A fixed interest rate means monthly payments stay the same, making it easier to budget.

Cons of Home Equity Loans

• Closing costs and fees: Lenders may charge closing costs of 2% to 5% of the loan amount. There may also be appraisal fees, loan origination fees and other fees.
• Fixed interest rates: Even if interest rates drop after you get a home equity loan, your interest rate and payment stay the same, so you won’t benefit from lower rates.
• Two mortgage payments: A monthly payment on a second mortgage could strain your finances, making it harder to save money or invest for retirement.
• Reduced equity: A home equity loan reduces your valuable equity. If you sell the home, you must repay the loan, diminishing your profits. Equity depends on home prices, so if home values decline, you could owe more than your home is worth.
• Risk of losing your home: Your home is collateral, so if you can’t make the loan payments, the bank can foreclose.

Home Equity Loan vs. Home Equity Line of Credit

Another way to borrow against your home equity is with a home equity line of credit (HELOC). A HELOC gives you access to a revolving credit line for a certain period, called the draw period. As with a credit card, you can borrow up to your credit limit; as you pay down what you’ve borrowed, you can borrow from the HELOC again.

Although both home equity loans and HELOCs use your home as collateral, there are key differences.

• Most HELOCs have variable interest rates (although fixed-rate HELOCs exist). Variable rates rise or fall based on the prime rate or other index, plus a fixed margin. If the index rises, your interest rate will too.
• HELOCs charge interest only on the amount you borrow, not on the entire credit line.
• HELOC payments may vary depending on interest rates and the amount you borrow.
• During the draw period, you typically make interest-only payments on the amount borrowed. Once the draw period ends, you repay the principal, usually over 20 years.

Alternatives to a Home Equity Loan

A HELOC isn’t the only alternative to a home equity loan. Here are some other options to consider:

• Get a personal loan. You can find personal loans for up to $100,000. As of May 2023, the average interest rate on a 24-month personal loan was 11.48%, according to the Federal Reserve. Like home equity loans, personal loans can be used for any purpose. They’re generally unsecured, so there’s no risk to your home, although failure to repay them can have major negative consequences on your credit.
• Apply for a personal line of credit. If your credit is good, you may qualify for a personal line of credit at a bank or credit union. Like HELOCs, these credit lines let you borrow up to a credit limit and pay interest only on what’s borrowed. You typically have three to five years to draw on the credit line and a similar time frame to repay it.
• Find money in your budget. Can you reduce expenses, get a side gig or sell belongings instead of borrowing?
• Use a credit card with a 0% introductory annual percentage rate (APR). Borrowers with good to excellent credit may qualify for credit cards offering 0% intro APRs on purchases for a limited time, typically 12 to 21 months. You can use the card to finance a big expense over time without incurring any interest by paying the balance in full before the promotional period ends. After that, you’ll pay a standard APR on any remaining balance.

Cash-out refinancing is normally a popular option for homeowners with equity, but record-high mortgage interest rates are currently making it a much less appealing option. A cash-out refi replaces your mortgage with a new, larger mortgage, while “cashing out” up to 80% of your equity. If you have $100,000 worth of equity and a $200,000 mortgage balance, for example, you could get a new mortgage for $280,000 and cash out up to $80,000 in equity.

Cash-out refinancing can make sense if the new mortgage has a lower interest rate than the old one—which isn’t likely these days. As of September 14, 2023, the average interest rate on a 30-year fixed rate mortgage was 7.18%—up from 6.08% a year prior, according to data from Freddie Mac.