What Is a Home Equity Loan?

A home equity loan lets homeowners borrow cash against their home’s value at relatively low interest rates. This makes home equity loans an appealing way to pay for large expenses, such as consolidating debts or major home improvements.

However, home equity loans pose risks because — like with your primary mortgage — your home secures the debt.

How Does a Home Equity Loan Work?

A home equity loan lets you borrow money using the value of your home as collateral. This typically allows mortgage lenders to offer larger loans and lower interest rates than other types of loans or credit.

Because the property serves as collateral, home equity loans are similar to mortgages, and sometimes are called second mortgages. Like with a mortgage, you’ll make a monthly payment that includes principal and interest until your loan balance is paid off. If you miss payments, the lender could foreclose on your home.

How much you can borrow depends on your credit and how much home equity you have.

How does home equity work?

Home equity is the difference between what your home is worth and how much you owe on it. Assuming you have one mortgage on your home, it’s the value of your home minus the balance of your mortgage.

You build equity by paying down your mortgage balance. Home equity also can increase when the market value of your home increases.

You can use your home equity in a number of ways, with how much equity you have determining how much you can borrow with a home equity loan. For example, if your home is worth $400,000 and you have a mortgage balance of $250,000, then your home equity is $150,000.

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How To Get a Home Equity Loan

Getting a home equity loan is similar to getting a mortgage. You’ll need to work with a lender that offers home equity loans, provide documents about your home and finances, and fill out a lot of paperwork.

First, you need sufficient equity. If your mortgage balance is more than 80% of your home’s value, you might not have enough equity to qualify for a home equity loan. Most lenders let homeowners borrow as much as 80% of their equity. Some may have higher limits, such as 85% or 90%.

Second, shop around and compare a few types of lenders. Look at their interest rates and fees, and try to choose the loan that best fits your financial needs and goals.

Once you’ve found a mortgage lender, you’ll need to apply for the loan. That means filling out an application and providing documents, such as mortgage or bank statements and pay stubs. Your lender likely will order an appraisal of your home to ensure it’s worth enough to secure a new loan.

If the lender approves your application, then you can sign the paperwork and close on the loan.

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Home Equity Loan Requirements

Qualifying for a home equity loan isn’t guaranteed. You’ll need to meet a few basic requirements.

Credit score

Lenders will look at your credit history and credit score when you apply for a home equity loan. Each lender will have its own specific requirements, but in general, borrowers with higher credit scores are more likely to be approved than those with bad credit.

Keep in mind that even if you’re approved, you might not qualify for the lowest possible rate unless your credit score is excellent.

Home equity

Your ability to get a home equity loan and how much you can borrow both depend on how much equity you have. The more home equity you have, the easier it will be to qualify and the more you can borrow.

While the specifics may vary from one lender to another, a common rule of thumb is that you can’t borrow more than 80% of your equity.

Debt-to-income ratio

Even if you have strong credit and plenty of equity, lenders want to make sure you can afford the payments on any new loan you apply for. Lenders will ask for proof of income and evaluate your ability to repay your new loan. You can provide that in the form of pay stubs or other proof that you can handle the loan payments.

Your debt-to-income ratio is the percentage of your gross monthly income that goes toward debt payments. Each lender will have different maximums, but a common one is that your debt-to-income ratio can’t exceed 43% after you get the home equity loan.

For example, if you make $6,000 a month and have $1,800 in monthly debt payments, your current debt-to-income ratio is 30%. The payment on a new home equity loan can’t add more than $780 to your total monthly debt obligation without exceeding the 43% DTI ratio, which caps your debt payments at $2,580 a month.

You can use our DTI ratio calculator to estimate your debt-to-income ratio.

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How Is a Home Equity Loan Paid Out?

With a home equity loan, you usually receive the money as a lump sum and pay it back with regular monthly payments.

Typically, your mortgage lender deposits the money directly into your bank account. You may be able to negotiate a different way of receiving the loan, such as a certified check. If you’re using the loan to consolidate debt, some lenders will help with that process by sending funds to your creditors or applying it toward loan balances you have with them.

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What Can You Do With a Home Equity Loan?

One of the benefits of home equity loans is that they’re flexible. There are few or no restrictions on how you can use the money. However, some uses make more financial sense than others.

Some common uses for home equity loans include:

• Funding home improvements — especially ones that increase the value of your home.
• Consolidating debts.
• Funding a new business.
• Covering emergency expenses.

Some situations where a home equity loan may not be the best choice are:

• Paying for a vacation.
• Luxury purchases.
• Investing in volatile assets or stocks.
• Buying a car.

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How To Repay a Home Equity Loan

Home equity loans are typically fixed-rate loans with loan terms in the range of five to 20 years. You’ll repay the loan through regular monthly payments. Keep in mind that home equity loan payments need to be made in addition to the payment on your primary mortgage.

Let’s say your home is worth $400,000, and you owe $200,000 on your primary mortgage. That would give you $200,000 in equity. If your lender lets you borrow up to 80% of your equity, then you could take out a loan for as much as $160,000. Borrowing the full amount would leave you with $40,000 in equity, which is 10% of the home’s value — meaning you’d have to pay private mortgage insurance until your equity passes the 20% mark.

If you want to borrow $50,000 to renovate your kitchen with a home equity loan at a 6% interest rate, here’s what you’d pay each month and in total interest over the life of the loan, with varying loan terms:

The longer the term, the lower the monthly payment but the more you pay in interest. Finding the right balance between what you can afford per month versus what you want to pay overall is an important factor to consider with a home equity loan.

If you sell your home during the repayment period, you must use the proceeds of the sale to pay off your mortgage and any home equity loans before you get to keep any of the money.

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Pros and Cons of Home Equity Loans

One of the main benefits of a home equity loan is that it’s “generally less expensive than other types of financing, such as personal loans or credit cards,” says Alex Capozzolo, the co-founder of the San Diego-based SD House Guys, a homebuying company.

However, it’s important to consider the risks as well.

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Home Equity Loans vs. HELOCs

Home equity loans and lines of credit are similar in that they both involve you borrowing money using your equity as collateral. While a home equity loan is paid out as a lump sum with a regular repayment schedule, a HELOC uses your equity to set a credit line that you can access when you need it. They also have different repayment methods.

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Home Equity Loans vs. Personal Loans

Personal loans differ from home equity loans in that they usually aren’t secured with collateral. That means lenders will approve a loan based on the applicant’s credit and overall financial standing. To get a personal loan, you don’t need to have built up home equity — or even own a home at all. Since the loan is unsecured, you’ll likely pay a higher interest rate than with a home equity loan.

“Home equity loans generally have lower interest rates than personal loans and can help you pay off your existing debt at the same time,” says Martin Orefice, CEO of Rent To Own Labs, a real estate business based in Orlando, Florida. “While easy access to cash and lower interest rates are attractive reasons to take out a home equity loan or HELOC, these types of loans can also put your house at risk if you fail to make payments.”

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Home Equity Loans vs. Cash-Out Refinances

Like a home equity loan, a cash-out refinance allows you to borrow your home equity as cash, though it does so by replacing your original mortgage with a new one. Tapping into your equity with a cash-out refinance requires a more thorough revamp of your finances, and is more of a long-term solution than a home equity loan.

Plus, with a mortgage refinance, you have to pay refinance closing costs, which average about $5,000. You’d need the savings on a cash-out refinance to be significant and to plan to stay with the loan long enough to pass the break-even point.

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Home Equity Loan FAQ

Here are answers to some frequently asked questions about home equity loans.

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The Bottom Line on Home Equity Loans

Home equity loans can be a valuable source of funds when you have a big expense to cover. But keep in mind that your home serves as collateral, which means your home will be at risk if you fail to make payments. Make sure you’re applying for a home equity loan for the right reasons, and take the time to shop around for a good deal.