How Does a Home Equity Loan Work?

How Does a Home Equity Loan Work? article image.

A home equity loan is a fixed-rate installment loan that allows you to borrow against a portion of the equity in your home. With a home equity loan, you can refinance costly debt, pay for large upcoming expenses and handle expensive emergencies, among other uses. There are some downsides to home equity loans, however, so it's important to know how these products work before pursuing one.

What Is a Home Equity Loan?

Sometimes called a second mortgage, a home equity loan is a lump sum of money you borrow against the equity in your home. Just as your first mortgage is secured by the property, so is the home equity loan.

Equity is the current market value of your home minus the amount you owe on your mortgage. It grows as you pay down your mortgage and as your home increases in value. For example, a home you originally purchased for $225,000 may now be worth $300,000. Time, increasing home values in your area and other factors have added $75,000 to your home's equity. If you've paid down your mortgage by $25,000, you have an additional $25,000 in equity—or $100,000 total.

Most lenders will let you borrow between 75% and 85% of your home's equity. So if you have $100,000 in equity, $75,000 to $85,000 may be available to you.

Home equity loans are fixed-rate loans, meaning your loan has a fixed interest rate that won't change and you'll repay it in fixed monthly installments. Terms typically range from five to 30 years.

How Is a Home Equity Loan Different From a Home Equity Line of Credit?

An alternative to taking out a lump sum is to borrow from your home equity as you need funds. Home equity lines of credit (HELOCs) provide a revolving credit line, similar to a credit card, with a credit limit based on your accumulated equity. You can tap into it for a specific number of years, called the draw period.

There are some notable differences between a HELOC and a home equity loan. With a HELOC:

  • Interest is only applied to the amount you borrow, and not to the unused portion of the credit line.
  • Interest rates are variable, and are based on the prime rate (or other index) plus a fixed margin. If the index your rate is based on goes up or down, so, too, will the interest rate.
  • Payments fluctuate according to the amount you owe and the interest rate.
  • If a balance remains after the draw period, a fixed repayment period begins, which is generally 20 years.

The downsides to HELOCs are similar to those you'd experience with home equity loans: The debt depletes your home's equity, and you could lose your home if you miss too many payments. What makes HELOCs unique, however, is the ability to use your credit line like that of a credit card, which could result in overuse. In addition, if the interest rate rises, the debt will be more expensive than you expected. If you make only minimum payments, you may end up with a large bill at the end of the draw period, and the new payments could be uncomfortably high.

Consequently, HELOCs are best for the things you can afford to repay quickly rather than extend out for a number of years.

Pros and Cons of a Home Equity Loan

There are plenty of pros to home equity loans. For example, interest rates are often low compared with credit cards, personal loans and even many HELOCs. Depending on how much equity you have, the amount of money you have access to can be large. You could even get a tax break: According to the IRS, if you use the equity loan to substantially improve your home, you may be able to deduct the loan's interest on your taxes.

As long as you can easily afford the payments, taking out a home equity loan could be beneficial if it helps you pay:

  • Uncovered medical or dental bills
  • Home and car repairs
  • Legal expenses
  • Larger-than-expected tax bills
  • Necessary travel costs

Paying off high-interest debt such as credit cards with money from a low-rate home equity loan can also be savvy, but should be approached with caution. If the bills were from overspending and you don't solve the underlying issue, you could rack up the balances again. At the same time, you're trading unsecured debt for secured debt, putting your home at risk.

Home equity loans do have drawbacks, however. Closing costs can run 2% to 5% of the loan, so a $100,000 home equity loan could cost you as much as $5,000. Using up your equity could keep you in debt longer, and you'll be committing to making payments over many years. If you fall behind on payments, the lender has the right to foreclose on your property.

Also, if your home's value drops, you'll owe more than the home is worth, which will be a problem if you need to sell it. For example, if your home is worth $300,000 but you owe $350,000, you'll take a loss rather than earning a profit you could use to help pay for your next residence.

Who Is Eligible for a Home Equity Loan?

While the equity in your home is yours to borrow, you still have to qualify for a home equity loan. Qualification requirements vary by lender, but in general you'll need a FICO® Score that's at least in the mid-600s. If your score is 700 and above, you'll have a greater chance of getting a home equity loan with good terms. Most lenders will also check your credit report, looking for consistent loan and credit card payments and a lengthy history of handling a variety of accounts responsibly.

Income is not listed on a credit report, so the lender will separately assess your debt-to-income ratio (DTI). This is the sum total of your monthly debt payments divided by your gross income. That number should not exceed 43%, but the lower your DTI is, the better.

You will also need to have sufficient equity in the home: Most lenders will require at least 15% to 20%.

Home Equity Loan Alternatives

As helpful as home equity loans can be, it's worth looking at viable alternatives:

  • Take out a personal loan. Most personal loans are unsecured, so you can avoid using your home as collateral. Although the interest rates won't be as low as they would with a home equity loan, as long as your credit scores are high, the rate may be low enough to make it worthwhile.
  • Find money in your budget. If you can reduce your expenses or sell unnecessary personal property to afford what you want, you can keep your home's equity intact.
  • Liquidate savings and investments. You may want to hoard the cash you've saved or funds that are growing in investment accounts, but weigh your options before you borrow against your home.
  • Use a HELOC. Maybe you don't need a large lump sum but are better off with a flexible cash flow. In that case, a HELOC may be preferable since it gives you the option to borrow only what you need.
  • Consider cash-out refinancing. Another option is to refinance your mortgage at a lower rate and withdraw cash at closing. The new loan will be higher than your current one since the amount you take out (plus any closing costs) will be added to the loan.

When you need a big influx of cash all at once, a home equity loan can be a good resource. You'll want to get the best rate possible, which means having a credit report that's populated with positive information. Check your credit report and credit score, which you can do for free with Experian, several months before applying. If you spot fraud or inaccuracies, dispute them, and if you've missed payments or your credit utilization is too high, take the time to make changes that will help you improve your credit score.