Home equity loan: what it is and how it works
Quick insights
- A home equity loan is a type of second mortgage that allows homeowners to borrow against the equity in their property, typically repaid at a fixed interest rate with monthly payments.
- These loans are provided in a lump sum and may be used for major expenses, such as home improvement projects or debt consolidation.
- Lenders have various qualification requirements but usually require a certain amount of equity in the home and limit the total loan amounts to 80% of the home’s value.
Are you looking to unlock the value of your home? A home equity loan, often referred to as a HEL or HELOAN, might be a good solution. This type of loan allows you to borrow against the equity you've built in your home, providing a way to access cash for big expenses like home renovations, education, debt consolidation or real estate acquisition.
With typically lower interest rates than personal loans or credit cards, a home equity loan could be an attractive option for individuals looking to make the most of their property investment. Let’s dive into the process and what you may want to consider before tapping into your home’s equity.
How does a home equity loan work?
Before borrowing against your home, it might be wise to understand how these loans work. Here’s a breakdown of how to get a home equity loan:
- Calculate your home equity: Home equity is calculated based on the difference between your home’s current market value and the remaining balance on your mortgage.
- Determine your borrowing amount: Loan providers typically allow you to borrow up to 80% of the property’s value, minus what you owe on your mortgage. A person should subtract all outstanding liens on the property, not just the existing mortgage. Your credit score, income and debt-to-income ratio (DTI) will also impact how much you can borrow.
- Apply for a home equity loan: To get a HELOAN, first compare mortgage interest rates, loan terms and fees from different lenders to find the best deal. Loan providers will evaluate your financial situation, credit history and home’s value. This may involve a home appraisal.
- Close on your loan and pay fees: Similar to a conventional mortgage, a home equity loan may come with closing costs, which could include appraisal fees, title insurance and origination fees. These costs can be significant, so you may want to factor them into your decision.
- Draw funds in a lump-sum payment: If approved, a home equity loan provides borrowers with a lump sum upfront, unlike a HELOC (home equity line of credit), which allows for more flexible access to funds over time.
- Repay the loan based on your terms: Most home equity loans have fixed interest rates, meaning your monthly payments remain the same over the life of the loan. Typical repayment terms range from 5 to 30 years. A longer term results in lower monthly payments but higher total interest costs. Your payments will include both principal and interest.
- Use the funds wisely: Many homeowners use the funds for home improvements, debt consolidation or emergency expenses. It might be a good idea to use the money for investments that could increase your home’s value or improve your financial situation.
Requirements to get a home equity loan
Home equity loans, like other financing options, come with certain requirements. Lenders will generally look for:
- Adequate home equity: Lenders typically prefer homeowners who have built up a significant amount of equity in their home already. Lower equity means less to borrow against, too.
- Stable income: As with any loan, lenders want to see consistent income that suggests you’ll be able to repay the loan.
- Good credit history: While not always mandatory, a good credit history can be beneficial.
- Low debt-to-income ratio (DTI): A lower debt load compared to your income indicates to lenders you could effectively handle new debt.
What can a home equity loan be used for?
Home equity loans can be used in various ways. Homeowners commonly use funds for:
- Home improvements: You can use the funds to upgrade your kitchen, bathroom or add extra space. These improvements could enhance the value of your home.
- Debt consolidation: Combine multiple high-interest debts, such as credit cards, into one loan with a lower interest rate, potentially saving on interest payments.
- Major expenses: Cover large expenses like buying a car, paying your college tuition or funding a wedding without taking on high-interest loans.
- Investment opportunities: Use the loan to invest in stocks, real estate or a business venture. Please keep in mind that this may come with inherent risks.
- Travel and experiences: You can also choose to finance a dream vacation or travel experiences that might otherwise be out of reach.
Pros and cons of a home equity loan
Home equity loans, like other financial products, come with their own set of potential advantages and disadvantages. Let’s look at what some of these might be to help you make a more informed decision:
Pros of home equity loans
- Fixed interest rates: Home equity loans typically come with fixed interest rates, meaning consistent monthly payments throughout the loan term.
- Flexible use: The funds from a home equity loan can generally be used for various purposes.
- Potential tax deductions: In some circumstances, the interest paid on a home equity loan may be tax-deductible. Speaking with your lender and a qualified tax professional can provide clarity as to whether this may be the case for your prospective home equity loan.
- Lump sum disbursement: Homeowners generally receive the loan amount all at once.
Cons of home equity loans
- Your home is collateral: Since the loan is secured by the home itself, there’s the potential risk of foreclosure if the loan isn’t repaid as agreed.
- Additional debt: Taking out a home equity loan means more debt, requiring additional financial management.
- Closing costs: As with an initial mortgage, a home equity loan may come with closing costs and other fees.
- Reduced equity: Borrowing against a home equity loan reduces the total amount of equity you have in your home.
Alternatives to home equity loans
While home equity loans are typically a popular option for accessing the equity in your home, there are alternative financing methods to consider:
- Cash-out refinancing: Replaces your existing mortgage with a new one for a higher amount. It allows you to access the difference in cash. This option may offer lower interest rates than home equity loans. It combines the first mortgage and cash-out portion into a single loan.
- HELOC: Functions like a credit card, allowing you to borrow against your home’s equity as needed. This option typically offers variable interest rates and provides flexibility to draw funds over time for various expenses.
In summary
A home equity loan allows you to borrow against the equity you’ve built in your home, possibly with more favorable terms than a more traditional loan. Keep in mind that you are borrowing against the equity you’ve built in your home and that failure to repay your home equity loan may have implications for your homeownership. Besides home equity loans, homeowners may consider alternatives, such as a HELOC or cash-out refinance to tap into available equity. Explore our home equity options to see what may work for your personal and financial goals.
Home equity loan FAQs
1. Is a home equity loan a second mortgage?
Yes, a home equity loan is sometimes referred to as a second mortgage. This is because it allows homeowners to borrow against the equity in their homes, similar to how a primary mortgage functions.
2. Can I get a home equity loan with bad credit?
It is possible to get a home equity loan with bad credit but it may be more challenging. Lenders typically assess your creditworthiness before approving home equity loans. A higher credit score might lead to better loan terms and interest rates. Other factors, such as the amount of equity you have in your home and overall financial situation, can also influence a lender’s decision. Speak with a home lending professional to better understand your options.
3. Are home equity loans worth it?
Whether a home equity loan is worth it largely depends on your personal goals and unique financial circumstances. A home equity loan can potentially offer a lower interest rate compared to other types of loans and can be used for various purposes. However, since your home serves as collateral, there are additional risks to consider if you were to default on the loan.
4. Do you need an appraisal for a home equity loan?
Yes, most lenders require a home appraisal for a home equity loan to determine the current market value of your home. This helps them measure the amount of equity you have—one of the key factors in the loan amount you might qualify for.
