What Is a Home Equity Loan, and How Does It Work?

A home equity loan is a second mortgage loan that you can use for various purposes, including debt consolidation, home renovations, college expenses, and more. 

Homeowners with significant equity can use some of it as collateral to take advantage of relatively low interest rates and long repayment terms. However, home equity loans can be costly upfront, and defaulting can have serious consequences. 

So what is a home equity loan and how does it work? Here’s what you need to know.

What is a home equity loan?

Home equity is essentially the difference between what your home is worth and how much you owe on your mortgage loan. To calculate your home equity, simply subtract your loan amount from your home’s value. 

For example, if your home is valued at $400,000, and your current loan balance is $275,000, you have $125,000, or 31.25%, in equity in the property.

A home equity loan allows you to access some or even all of that equity by using it as collateral to secure a second mortgage. The lender will disburse the loan as a lump sum, which you can use for just about anything you want. Then, you’ll make fixed monthly payments for the life of the loan to pay it back.

How does a home equity loan work?

A home equity loan works similarly to a mortgage, but instead of using the loan funds to buy a new house, you’re tapping equity you have in your existing home and using that money however you want.

You can get a home equity loan from the same lender that services your primary mortgage loan, or you can apply with a different lender. Here are some of the main features of a home equity loan:

• Loan amounts: Depending on the lender, you may be able to borrow anywhere from $10,000 to $1 million or more, depending on the lender.
• Loan-to-value limits: The amount you can borrow will be based on how much equity you have in your home. Between your primary mortgage and your second mortgage, lenders typically allow you to borrow up to between 80% and 90% of your home’s value—this is called your loan-to-value ratio (LTV)—though some may go as high as 100%. With a $400,000 home, a $275,000 mortgage balance, and a 90% LTV limit, for example, you can borrow up to $85,000 with a home equity loan.
• Repayment terms: You’ll make fixed monthly payments over a set period of time. Depending on the lender and how much you borrow, your repayment term may be anywhere between five and 30 years. If you sell your home before then, you’ll use the sales proceeds to pay off the loan.
• Interest rates: Home equity loan interest rates are typically fixed, which means they stay the same for the life of the loan. They tend to be slightly higher than traditional mortgage rates but lower than other forms of credit like personal loans and credit cards.
• Other costs: Similar to a traditional mortgage, some home equity lenders charge closing costs ranging from 2% to 5% of your loan amount. However, many lenders don’t charge any closing costs at all, though they may charge a higher interest rate to compensate for that. 

Because having a home equity loan means another monthly payment, it’s crucial that you review your budget to make sure you can afford the additional obligation.

How to qualify for a home equity loan

Each lender has its own set of eligibility criteria. But in general, here are the requirements you’ll need to meet to qualify:

• Good or excellent credit (see more about that below).
• Significant equity in your home—most lenders require you to have at least 20% equity in your home, although some will go as low as 15%.
• An appraisal to determine how much your home is worth. This amount may be higher or lower than what you paid when you bought the home. 
• A debt-to-income (DTI) ratio of 43% or lower, although some lenders may go as high as 50%. Your DTI is the percentage of your gross monthly income that goes toward debt payments.
• A steady source of income, which may be a full-time job, self-employment or even retirement income.  

What is the minimum credit score for a home equity loan?

Minimum credit scores typically range from 620 to 680, but some lenders may be willing to go lower. To maximize your chances of getting approved and securing affordable terms, your best bet is to have a credit score in the 700s. 

If you’re not certain what your credit score is, you can check it with a free service like AnnualCreditReport.com. You can also review your credit report to understand which factors are influencing your credit score and determine how you can address potentially negative items. 

Here are just a few examples of what to expect from a few home equity lenders:

Lender	Minimum credit score	Maximum DTI	LTV limit
Spring EQ	640	50%	95%
Discover	620	43%	90%
Rocket Mortgage	680	45%	90%

Pros and cons of a home equity loan

If you’re considering a home equity loan, it’s important to understand both the advantages and disadvantages that come with them and how they apply to your situation. Here’s what to keep in mind.

Pros

• Relatively inexpensive

  Compared to personal loans and credit cards, a home equity loan can provide you with lower interest rates and lower monthly payments. Even if a lender charges closing costs, it can be cheaper than, say, a cash-out refinance, which would base closing costs on a much larger loan amount.

• Interest rates are fixed

  Home equity loan interest rates are fixed, so you don’t have to worry about your rates increasing over time as you would with a home equity line of credit—more on that in a minute.

• You could enjoy tax benefits

  If you use your home equity loan funds to buy, build, or substantially improve the home you used as collateral for the loan, you may be able to deduct the interest you pay on the loan when filing your tax return every year. That said, other loan uses don’t qualify for a tax break.

Cons

• You need to use your home as collateral

  Using your home equity to secure the loan is why you can get a relatively low interest rate. But that also means that if you fail to repay the debt, the lender can foreclose on your home.

• They can cost a lot in the long run

  If your lender charges closing costs, that can increase your overall costs compared to other loan options. And while a longer repayment term can help keep your payments low, that also means more total interest charges.

• Requirements can be strict

  While some lenders are willing to work with borrowers with lower credit scores, you’ll need to have good or excellent credit to get approved with most lenders.

How do you know if a home equity loan is right for you? According to Erin Kinkade, CFP, it depends on your situation. 

“If you cannot qualify for a home equity loan or HELOC and need—not want—the loan urgently, or if you do not want your home as a collateralized asset, I would direct you to shop for personal loans or borrow from a trusted family member (of course, this has to be handled with care and caution),” says Kinkade.

“If you can be approved for a home equity loan or HELOC and are not risk averse to having your home as collateral,” she says, “then shop for a home equity loan or HELOC.”

How to apply for a home equity loan

Before you get started, it’s important to evaluate your situation. Check your credit score and credit reports and get an estimate of how much equity you have in your home. Also, be sure to research all of your options to make sure that a home equity loan is the right fit for you. 

From start to finish, it can take anywhere from two weeks to two months to get a home equity loan. Once you’ve decided to move forward with a home equity loan, here are the steps you’ll take.

Shop around

Take some time to shop around and compare home equity loans from multiple lenders. In addition to interest rates, you’ll also want to evaluate loan amounts, repayment terms, LTV limits, closing costs, and eligibility criteria.

It’s generally best to compare terms from at least three to five lenders to understand what you qualify for and which lender can offer the best deal. 

Submit an application

Depending on the lender, you may be able to apply online, over the phone or in person. Some of the information you’ll need to provide includes:

• Full name
• Social Security number
• Date of birth
• Physical address
• Employer and income information

You’ll typically need to provide the following documentation:

• Copy of your government-issued photo ID
• Proof of income, such as a pay stub, recent W-2 form, bank statements or tax returns
• Current mortgage statement
• Recent property tax bill
• Copy of your homeowner’s insurance policy

Depending on your situation, you may also need to provide other documents, so check with your lender before applying to ensure you have everything ready to go.

Submit to an appraisal

Lenders will typically require an appraisal to get a firm idea of what your home is worth. This will help the lender determine how much you can borrow. An appraisal typically costs between $300 and $500.

Agree to the terms

If you’re approved, the lender will provide you with a disclosure outlining the loan terms. Review the agreement carefully before signing. If the loan requires closing costs, have the money ready using the lender’s preferred payment method. 

Once you sign the loan agreement, the loan funds will be disbursed to you based on the lender’s policy. 

Home equity loan vs. home equity line of credit (HELOC)

One of the other options homeowners have is a home equity line of credit, or HELOC for short. While both are considered second mortgages and use your home’s equity as collateral, there are some significant differences between the two.

For starters, a HELOC provides you with a revolving line of credit you can use repeatedly during your draw period. After that, you’ll enter a repayment period, during which you’ll pay down the debt. Here are some other features to compare:

In general, a home equity loan can be a good idea if you have a one-time project or expense and don’t need ongoing access to credit. It can also be more appealing to borrowers who prefer the predictability of a fixed interest rate.

Alternatively you may consider a HELOC if you want ongoing access to a revolving credit line or like the idea of low interest-only payments throughout your draw period. While a variable interest rate can be risky, it can also benefit you if market interest rates drop. 

Additionally, some HELOC lenders may allow you to convert some or all of your balance to a fixed-rate loan.

What can you use a home equity loan for?

You can use a home equity loan for anything you want. However, because you’re putting your home at risk when using it to secure a debt, it’s best to avoid applying for a home equity loan for unnecessary expenses. 

Some of the most effective ways to use home equity loan funds include:

• Home improvements
• Debt consolidation
• Emergency expenses
• College costs
• Wedding or funeral expenses
• Medical bills

Alternatives to a home equity loan

Before you apply for a home equity loan, it’s important to research all of your options. Here are some potential alternatives to consider:

• HELOC: A HELOC can be a better choice if you want ongoing access to credit and low interest-only payments for a time. However, the variable rate may increase your overall costs over time.
• Cash-out refinance: A cash-out refinance loan involves replacing your current mortgage loan with a new one, plus the amount of equity you want to access, which will be paid out to you in cash. This option can be worth considering if you can get a lower interest rate than what you’re paying on your current primary mortgage. However, the higher loan amount will result in more closing costs.
• Personal loan: Personal loans are generally unsecured, so you don’t have to worry about losing your house. They typically offer repayment terms ranging from one to seven years, and many lenders don’t charge upfront fees. They can also offer lower interest rates than credit cards, especially if you have good credit. However, they may not be suitable for larger financing needs or for borrowers with less-than-stellar credit.
• Credit cards: If you have smaller financing needs, you may consider a credit card with a 0% APR promotion on purchases or balances transferred from another credit card. That said, these cards typically require good or excellent credit, and they may be less suitable for larger projects and needs.   

As you consider all of your options, evaluate your current situation and needs and your financial goals to determine which is best for you.

Ask the expert

Erin Kinkade

CFP®

Evaluate your budget in a realistic manner to ensure you can repay the loan/credit borrowed in a timely manner so as not to get yourself in a tight financial situation. Ideally, your cash flow allows for repayment and personal savings. And, evaluate the purpose for borrowing to ensure it fits into your financial and life goals. Is the loan a need or a want? Would waiting to borrow will be more beneficial?

Frequently asked questions

How do I choose the best home equity loan provider?

Shop around and compare interest rates, loan amounts, repayment terms, and other features across the best home equity lenders to determine which one offers the best deal for you. In some cases, you may be able to get pre-qualified for a home equity loan, allowing you to view potential terms with no impact on your credit score.

Is interest on a home equity loan tax-deductible?

You may be able to deduct the interest you pay on a home equity loan, but only if you use the funds to buy, build, or substantially improve the home you used to secure the loan.

Can I refinance a home equity loan?

Yes, it’s possible to refinance a home equity loan using another home equity loan, a HELOC or a cash-out refinance loan. You can also use a home equity loan to refinance a HELOC.

What happens to my home equity loan if I sell my house?

Just like your primary mortgage loan, you’ll typically use the proceeds from the sale to pay off your home equity loan.

How does a home equity loan affect my credit score?

A home equity loan affects your credit score like other installment loans do. When you apply, the lender will run a hard inquiry on your credit reports, which can have a small, temporary impact on your credit score. 

Credit scoring companies will also consider the total amount of debt you have, including your home equity loan. As you make on-time payments, your home equity loan can help improve your credit. But if you miss a payment or default, a negative payment history or foreclosure could have a significant negative impact on your score.

Can I have a home equity loan and a HELOC simultaneously?

Yes, it’s possible to have both a home equity loan and a HELOC simultaneously, even using the same house as collateral. Just keep in mind that the LTV limit applies to both your home equity loan amount and your HELOC credit limit, so you’ll likely need to have a significant amount of equity in your home to qualify. 

How does a home equity loan work for home renovation?

Whether you’re doing renovations on your own or hiring a contractor, you’ll receive the proceeds from your home equity loan in a lump sum, allowing you to spend the money when and how you wish.