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

Article Summary:

A home equity loan, also known as a second mortgage, is a way to borrow money using the equity in your home as collateral. You can typically borrow up to 80%, give or take, of the home’s equity. Since the debt is secured by your house, interest rates are also lower than many other types of consumer loans. The main drawback is, since your house secures the loan, the bank can foreclose on your home if you default on it.

There are a lot of good reasons for needing a lump sum of cash. Repairs or renovations to your house, consolidating high-interest debt, or paying for college tuition are just a few examples. Home equity loans are just one of the ways to achieve those goals, and this form of financing comes with multiple benefits.

However, home equity loans also come with a fair share of risks. Read on to learn more about what home equity loans are, how they work, and what you need to qualify for them. We’ll also take a look at a few alternatives to home equity loans. First, let’s discuss when and why a home equity loan might make sense for you.

What is a home equity loan?

A home equity loan, also known as a second mortgage or a home equity installment loan, is a means to borrow money by leveraging the equity you’ve built up in your home. To secure the loan, the house is put up as collateral.

Lenders determine the loan amount by how much equity you’ve built up and the appraised value of the home. Lenders will typically let you borrow up to 80% of the equity in your home. For example, if your home’s appraised value is $500,000 and your current mortgage balance is $200,000, your total equity is $300,000. Since $240,000 is 80% of your equity, that means you could potentially borrow $240,000, which is no small sum.

Because home equity loans are secured by the house, just like your primary mortgage, you can typically get better interest rates than with a personal loan, for instance. However, home equity loan rates are usually higher than interest rates for your primary mortgage because the risk is higher for the lender.

Most home equity loans also come with closing costs (although some financial institutions will waive closing costs), so make sure you factor that in when determining the total cost of the loan. Most closing costs amount to between 2% to 5% of the entire loan amount.

IMPORTANT! Since the loan term for a home equity loan is usually between five and 20 years, it’s important to calculate what you can afford for monthly payments to get the optimum loan term. Keep in mind that a shorter loan term will come with a higher monthly payment.

How does a home equity loan work?

If you’re approved for a home equity loan, you’ll receive the money in one lump sum to use however you want. You also need to start paying it back right away, much like a car loan or your primary mortgage. Home equity loans come with a fixed interest rate, which means you will repay the loan in predictable, equal monthly payments.

This is a nice benefit of home equity loans as a predictable payment makes budgeting much easier. By comparison, home equity lines of credit (HELOCs) usually have variable interest rates, which means your monthly payment will vary up or down as the interest rate fluctuates.

Why get a home equity loan?

If you find yourself in need of a large sum of money relatively quickly, using the equity you’ve built up in your house can be a good way to put that money to use. After all, if you’ve been diligently making your monthly payments, the money you’ve built up in equity is just sitting there and could be put to much better use.

Unless you’re planning to sell your house in the near future, this is one of the most cost-effective ways to leverage your home’s equity. This is particularly true if borrowing money for the purpose of home improvement projects because you can potentially increase the market value of your home.

If you do have plans to sell within the next couple of years, and you’re not planning to make any renovations, you may want to rethink a home equity loan. Depending on the loan amount and what’s going on in the housing market, you could potentially end up losing money in the sale if you owe more than your house is actually worth.

When should you get a home equity loan?

In general, there are certain times when applying for a home equity loan is better than other financing options. Here are some basic reasons why a home equity loan might make sense for you.

  • You need a lump sum of money. If your plans for the home equity loan are to consolidate debt, fix up your house, pay for college, or start your own business, those are solid uses for the loan. Plus, you can typically get a better interest rate than you would get with a personal loan or other consumer loans.
  • You have a good income. Don’t get a home equity loan if the monthly payment is going to stretch your budget to the point where you might default on the loan.
  • You know how much money you need. Because you’re putting your house at risk by taking out a home equity loan, it’s best to know exactly how much you need for your purpose. Maybe you need $10,000 for a new roof, $15,000 to pay off your credit card debt, or $20,000 for tuition. The point is, only borrow as much as you need.
  • You have a low debt-to-income ratio (DTI). If you already have a lot of debt in relation to your income, a home equity loan might not be the right choice for you. In fact, if your DTI is too high, many lenders may not even qualify you for a home equity loan.

If you recognize yourself in the above list, start looking for a home equity loan now. Use the tool below to compare your available options and loan rates to find the best home equity loan for your situation.

How to qualify for a home equity loan

Since you’re responsible for the equity built up in your home, you’d think you would have easy access to this equity. However, you still need to qualify for home equity loans just like you did with your primary mortgage.

This means that lenders like banks or credit unions will examine your credit score and credit history. This is in addition to your income and debt-to-income ratio (DTI) and your home equity and loan-to-value ratio (LTV) to determine your interest rate and loan term.

Home equity

As mentioned, the amount of your home equity is the difference between your current property value and the remaining balance owed on your mortgage. This means you’ll need to get an appraisal to determine your home’s current property value.

This also helps the lender determine the loan-to-value ratio. This is calculated by dividing the requested loan amount by the home’s current market value and is expressed as a percentage. Ideally, the LTV should be 80% or less to qualify for a home equity loan.

Credit history

Your credit history is an important part of the loan approval process. This is why lenders will carefully look at your credit scores and overall credit report to ensure that you are a person who is responsible with managing debt and has a history of on-time monthly payments. Credit score requirements vary, but many lenders won’t approve someone with a score of 620 or less.

Pro Tip

Before you apply for a home equity loan, make sure you review your credit report for any inaccuracies. Fortunately, you can get a free credit report every year from each of the credit bureaus.

Income and debt-to-income ratio

Even if you earn an excellent income, lenders still want to assess your DTI to make sure that a home equity loan won’t cause you to overextend your monthly expenses and thereby cause you to default on the loan.

Your debt-to-income ratio is calculated by dividing your total monthly debt payments by your gross monthly income. For example, if you pay $1,000 a month in debt and your income is $5,000 a month, your DTI would equal 20%. This is a very good DTI, as lenders typically want to see a DTI that’s under 40%. That said, increased competition from online lenders means you might be able to get away with a higher debt-to-income ratio, particularly if your other loan criteria are in good shape.

Alternatives to home equity loans

Depending on your financial situation, a home equity loan may not be the right way for you to take advantage of the equity in your home. Luckily, you have a few other options to consider.

Home equity line of credit (HELOC)

A home equity line of credit also converts your house’s equity into usable cash, and borrowers often spend the money on similar uses such as home repairs or credit card bills. You will also probably have to pay closing costs on home equity lines. However, there are a few key differences between HELOCs and home equity loans that you should be aware of.

For instance, instead of receiving a lump sum of cash like you would with a home equity loan, you are extended a credit line much like a credit card. You can access that credit line as often as you need it, up to the credit limit, for a draw period of (usually) ten years. Throughout this draw period, you’ll only make interest payments on the funds you spend.

After the draw period, you enter the repayment period and can no longer access those funds. Then your monthly payments will consist of both principal and interest.

It is important to note that while a home equity loan comes with a fixed interest rate, HELOCs usually have a variable interest rate, meaning you won’t have equal monthly payments. Having fixed installments sometimes makes it easier to fit a new payment in with your existing monthly expenses.

A home equity line of credit can make sense for borrowers who don’t need a lump sum right away but would like access to cash for various future expenditures or projects. The flexibility of being able to use the money, pay it back, and use it again can be an attractive feature for many homeowners. To get a better idea of the rates you may qualify for, take a look at the HELOCs available using the tool below.

Cash-out refinance

A cash-out refinance pulls equity out of the house by swapping your existing mortgage with a new mortgage loan, “cashing out” your equity in the process. The new mortgage is used to pay off the original mortgage balance and you get the remaining equity as a lump sum payment, much like a home equity loan transaction.

It should be noted that a cash-out refinance can be more difficult to get credit approval for because the new mortgage is a higher loan amount than your current mortgage balance. This also means you might need to be prepared for higher mortgage payments (depending on interest rates). That said, at least you won’t have two mortgage payments to manage as you would with a home equity loan. Also, keep in mind that cash-out refinances might have a variable interest rate or a fixed interest rate.

Shared equity agreement

A shared equity agreement (aka home equity investment) is also a way to access the equity in your house, but it’s a little different than your other options. Shared equity agreements are not technically even a loan at all and involve giving an investor or investment firm a share in the future value of your home in exchange for one lump sum of cash.

You receive the funds immediately and typically repay the initial investment plus a fixed percentage in the change in the home’s value when you sell the house (or the contract is up). However, remember that the investor shares in either the increase or the decrease in the home’s value. This means that if, at the time of the sale, the home value has increased, the investor shares in that increase. But if the value decreases the investor shares in the losses as well.

The really nice thing about shared equity agreements is there are no monthly payments or interest rates to worry about. The downside is you are giving away some of the value in your home. But these agreements can be easier to qualify for because minimum requirements for credit history and income are less strict.

Pro Tip

If you’re in the market to borrow a large sum of money, be sure to compare rates and terms on different loan types. You may find that an alternative such as a home equity line of credit or a cash-out refinance is a better loan choice for your financial circumstances.

FAQs

Is the interest on my home equity loan tax deductible?

If you’re counting on the interest you paid on your home equity loan as being tax deductible, you could be in for a rude awakening. While the interest on your first mortgage is tax deductible, you can only get a tax break on your home equity loan’s (or home equity line of credit’s) interest if you ” buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the Internal Revenue Service (IRS).

It’s important to be aware of this rule if you plan to use the home equity loan for anything other than home improvements or renovations and were banking on getting a tax break. However, keep in mind that the tax deduction is basically a moot point if you generally take the standard deduction, which varies based on your filing status.

What is the difference between a home loan and a home equity loan?

A home loan is just another word for “mortgage,” which is the original loan used to purchase your house. A home equity loan is a second mortgage on top of your existing mortgage. That means you are responsible for a monthly mortgage payment for each loan.

Is it better to take out a home equity loan or pay cash?

If it’s feasible for you to pay cash for a new roof or a down payment on a car rather than taking out a home equity loan, that would be your best option. Getting into unnecessary debt is never a good idea if you have other means.

On the other hand, if you’re using your entire emergency fund from your savings account to pay for a major expenditure, that’s also not a good idea because it leaves you vulnerable to future emergencies such as a job loss. So be sure to consider all of the pros and cons of each financing option.

Key Takeaways

  • A home equity loan allows you to borrow against the equity built up in the home, using the house as collateral.
  • Consumers typically use home equity loans for debt consolidation, home improvements, or starting a business.
  • Home equity loans are disbursed in one lump sum and come with a fixed interest rate and fixed monthly payments.
  • You can typically get better interest rates with home equity loans than you could with an unsecured personal loan.
  • Loan terms are generally more favorable for a home equity loan than for other consumer loans. However, you often have to pay for closing costs plus an appraisal, which add to the loan cost.
  • The interest you pay on your home equity loan is only tax deductible if you use the money for substantial home renovations or other improvements.
View Article Sources
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  2. Home Equity Loans and Home Equity Lines of Credit — Federal Trade Commission
  3. Interest on Home Equity Loans Often Still Deductible Under New Law — IRS
  4. Home Equity Loan vs. Line of Credit: Which Should You Choose? — SuperMoney
  5. What Is a Second Mortgage? (And How To Get One) — SuperMoney
  6. How to Tap Into Your Home Equity Without Getting Into Debt — SuperMoney
  7. What’s the Best Way to Finance Home Improvement Projects — SuperMoney
  8. Personal Loan vs. Home Equity Loan: Which Is Better? — SuperMoney
  9. How To Get Equity Out Of Your Home — SuperMoney
  10. Are Home Improvement Loans Tax Deductible? — SuperMoney
  11. Reverse Mortgage vs. Home Equity Loan vs. HELOC: Pros & Cons — SuperMoney
  12. Best Home Equity Loans — SuperMoney
  13. Best Home Equity Loans For Self Employed Borrowers — SuperMoney
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  15. FB&T Home Equity Loan — SuperMoney
  16. First Bank and Trust Home Equity Loan — SuperMoney
  17. Capital Bank Home Equity Loan — SuperMoney
  18. PenFed CU Home Equity Loans — SuperMoney
  19. Discover Home Equity Loans — SuperMoney