What is a Home Equity Loan and How Does It Work?

For most people, their home is the most expensive thing they’ll ever own, and it usually takes a large loan, called a mortgage, to be able to buy one. As you pay off your mortgage balance, you build equity in your home, with your equity equaling the difference between your mortgage balance and the value of your home.

It can be frustrating to have so much money tied up in a single asset, but there are ways to turn your equity into cash. Many lenders offer home equity loans that use the equity that you’ve built as collateral. This means that you can get lower interest rates and higher loan amounts than you could with most other types of loans.

This guide will discuss the most common questions people have about home equity loans and how you can make the most of one.

In this guide:

• What is a home equity loan?
• What can a home equity loan be used for?
• How much money can you get from a home equity loan?
• What are the requirements to get a home equity loan?
• Are home equity loans a good idea?
• Applying for a home equity loan is a multi-step process
• How does repayment work with a home equity loan?

What is a home equity loan?

A home equity loan is a type of loan secured by the equity that you’ve built in your home. Assuming your home’s value remains the same, you can build equity as you pay down your balance. The difference between your home’s value and your mortgage balance is the amount of equity you have—for example, if you have a home worth $400,000 and owe $300,000 on your mortgage, you have $100,000 in equity.

Home equity loans work very similarly to mortgages. Sometimes, they’re even called “second mortgages.” You receive a lump sum of cash limited by the equity you have in your home (most lenders won’t give you a loan for more than the equity you’ve built). After you receive the money, you make regular monthly payments until you pay the loan off.

Like a mortgage, home equity loans are secured by the value of your home. That means that they typically offer lower interest rates than unsecured loans—like personal loans or credit cards. Repayment terms can vary, just like a mortgage. Depending on the lender, you can take between five and 30 years to repay the money that you borrow.

One important thing to keep in mind about home equity loans is the risk they present. If you use your home to secure a loan, you’re putting your home at risk if you’re unable to make your loan payments. Failing to repay a home equity loan may lead to foreclosure. Unsecured loans, on the other hand, do not specifically put your home at risk.

What can a home equity loan be used for?

One of the best things about home equity loans is that you can use them for anything. Some of the most popular uses for home equity loans include:

• Home Improvements
• Consolidating debts
• Paying for educational costs
• Purchasing a second home
• Purchasing other investments

How much money can you get from a home equity loan?

The primary factor that determines how much money you can borrow with a home equity loan is the amount of equity you’ve built in your home. The more equity that you have, the more you can borrow.

Typically, lenders will let you know how much you can borrow using a loan-to-value (LTV) ratio. This is the ratio of how much you can borrow compared to your total equity. Most lenders limit your borrowing to 80% to 90% of your equity. For example, if a lender has an LTV limit of 90% and you have $100,000 in equity, you can borrow up to $90,000. You can use our home equity calculator to get an estimate of how much you can borrow.

With a home equity loan, like a mortgage, you will need to pay closing costs. Closing costs usually range from 2% to 5% of the amount that you borrow. You might also have to pay points—an extra fee that chips away at the interest rate—to secure the rate that you want. Work with your lender to figure out the exact amount that you’ll pay in fees and keep those costs in mind when comparing different home equity loans.

What are the requirements to get a home equity loan?

Though the specific requirements vary from lender to lender, there are a few things that you’ll need to qualify for a home equity loan.

• A reasonable amount of equity: It’s important to keep in mind that, depending on your lender’s LTV, you can typically only borrow between 80% to 90% of your equity. That means that if you haven’t paid much toward your home yet, you may not be able to get a home equity loan that covers its intended purpose.
• A good credit score: Having good credit makes it easier to qualify for loans. While home equity loans might be easier to get than other types of loans due to the security that using your home as collateral provides, good credit will help you secure a good interest rate. (If you don’t have good credit, find out how to qualify for a home equity loan with bad credit.)
• A good debt-to-income ratio: Lenders want to know that you can make payments on your loan. The lower your debt-to-income ratio, the easier it will most likely be for you to make monthly payments.
• A source of income: Your lender might ask for copies of your paystubs or other proof of income, so it knows you’ll have a way to repay the loan.

Are home equity loans a good idea?

There’s no single answer to whether a home equity loan is a good idea, as it depends on your financial situation and how you plan to use the money. For example, it may be a sounder idea to use a home equity loan to consolidate debt and reduce your interest rates than to use the loan to fund a vacation.

Applying for a home equity loan is a multi-step process

1. Check your credit and your home’s value to make sure you can qualify for a loan.
2. Figure out how much you want to borrow.
3. Compare lenders and choose one to work with.
4. Fill out an application. You’ll provide personal identifying information and financial information during this step.
5. Work with your lender to select a loan amount and payment term that work for you.
6. Receive the cash and start making monthly payments.

If you are ready to apply, compare the best home equity loans.

How does repayment work with a home equity loan?

Repaying a home equity loan works very similarly to repaying a mortgage. Most home equity loans are fixed-rate loans, so you have a set monthly payment. Interest rates are usually a little bit higher than mortgage interest rates, but depending on the lender, you can choose from a variety of repayment terms—some lenders offer terms of up to 30 years.

Home equity loans also carry similar fees to mortgages. You have to pay closing costs, and if you miss a payment or make a late payment, that brings fees, too. Late or missed payments can also damage your credit. On the bright side, making timely payments will help you build credit over time.

Home equity loan interest can be tax-deductible

The IRS allows a tax deduction for people who borrow money to purchase a home. Depending on where you originated your loan, you can deduct interest on loans of up to $750,000 if you’re filing as a single person or $1,000,000 if you’re filing jointly with a spouse.

Typically, this applies to mortgages, but you may also be able to deduct home equity loan interest. The IRS says that home equity loan interest is deductible if you use the funds only to “buy, build or substantially improve” your home.

What are the alternatives to home equity loans?

If you need to borrow money, a home equity loan isn’t the only option available. There are plenty of home equity alternatives.

HELOCs

A home equity line of credit turns your home into a revolving line of credit, much like a credit card.

When you open a HELOC, you don’t receive a lump sum of cash. Instead, you get a credit limit based on your equity in the home. When you need to borrow money, you can tap your HELOC for funds. If you don’t need to borrow anything, you can let the HELOC sit unused.

When you use your HELOC to borrow cash, you’ll get monthly bills, just like a credit card. Make payments each month to pay down your balance. If you need to borrow more from your HELOC while you have a balance, you can do that as long as you stay under your credit limit. If you pay your HELOC balance off, you can always use your HELOC to borrow more cash.

You shouldn’t automatically open a HELOC as a precaution, when you build enough equity. Home equity lines of credit do carry fees, such as origination fees and annual fees. Still, a HELOC can be a great way to meet changing financial needs.

>> Read More: Home equity loan vs. HELOC

Cash-out refinance

A cash-out refinance replaces your existing mortgage with a new one. You take the difference in the balance of the old loan and the new one as cash. You can use that money for any purposes, such as paying off other debts, improving your home.

One benefit of a cash-out refinance over a home equity loan is that it leaves you with just one loan payment to make. If you have a mortgage and open a home equity loan on top of it, you’ll have to make monthly payments on both.

Cash-out refinances reset the term of your mortgage, meaning you’ll take longer to pay off your home, but they’re a good way to get cash out of your home if you need it.

>> Read More: Best cash-out refinance companies

Reverse mortgage

Reverse mortgages are typically targeted at older homeowners who need a source of regular income and who have a lot of equity in their homes.

With a reverse mortgage, the lender either offers a lump sum to the borrower or makes monthly cash payments to them, using the value of the home as collateral. The borrower doesn’t make any payments. Instead, the loan comes due when the borrower passes away, moves, or sells the home. Typically, the home is sold to repay the lender and cover the balance of the loan.

>> Read More: Best reverse mortgage companies

Unsecured personal loan

Unsecured personal loans are basic loans that give you money without collateral of any kind. This means that you don’t have to put your home at risk, but unsecured personal loans come with a few drawbacks.

One of the primary drawbacks of unsecured personal loans is that they have higher interest rates than secured loans. That means you’ll pay more to borrow money when you take on out. This compensates for the higher risk the lender takes.

Lenders also reduce their risk by limiting the amount you can borrow—typical personal loans max out in the region of $35,000, though some lenders may offer as much as $100,000 if you have high income and good credit.

Unsecured personal loans can also be harder to qualify for than secured loans. You need to have good credit to qualify and get the best rates, and people with lower credit scores may have trouble qualifying at all.

Personal loans tend to be best for small, short-term financial needs like unexpected bills or consolidating multiple credit cards bills into single monthly payments.

>> Read More: Best personal loan companies