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What is a home equity loan? Home equity loans and HELOCs explained

Craig Berry
The Mortgage Reports contributor

Put your equity to work with a home equity loan or refinance

Plenty of Americans are equity-rich.

The average homeowner gained more than $5,000 in home equity last year. And in some states, households gained more than $20,000.

A home equity loan is one way to tap into your home’s cash value.

Since a home equity loan is secured against your house, it has a much lower interest rate than other borrowing options — like personal loans or credit cards.

However, home equity loans and HELOCs (home equity lines of credit) still have higher interest than cash-out refinances. So consider your options carefully.

Access your home equity with a cash-out refinance (Aug 15th, 2020)

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How home equity loans work

When you apply for a home equity loan, the amount you can borrow is determined by the existing equity in your home. That’s the difference between the value of your home versus what you owe on your mortgage.

Also referred to as a second mortgage, a home equity loan is a way to access that equity without selling the home or refinancing.

Unlike a traditional mortgage — one you use to buy a home — you can use the money borrowed with a home equity loan for whatever you like.

The equity can even be used even if it’s not related to your home. Home equity loans are often used to finance major expenses such as:

  • Medical bills
  • College education
  • Vacation
  • A new car
  • A second home
  • Home repairs
  • Home improvements

>> Related: The 6 best home improvement loans

While this can make a home equity loan sound appealing, it’s important to remember that it’s a secured loan. This means you’re using your property as collateral.

When you get a home equity loan, a “lien” is created against your house and reduces your actual home equity.

A lien gives the lender the right to foreclose on your home if you can’t repay your loan as agreed. So, as with any large loan, there are risks involved.

How can I borrow with a home equity loan?

Not all lenders offer home equity loans. The ones that do can typically lend up to 80–90% of your home’s equity.

For example, say you purchased your home five years ago and it’s now worth $300,000. You owe $200,000 on your mortgage. You now have $100,000 worth of equity. But odds are, you could only borrow around $55,000.

Here’s how to calculate that, assuming you don’t have any other liens on your home.

  • Home’s appraised value: $300,000
  • Mortgage loan balance: $200,000
  • Equity in your home: $100,000
  • Calculate 85% of your home’s current value: $300,000 x .85 = $255,000
  • Subtract the $200,000 that you currently owe:
  • Total equity available to borrow: $55,000

You’ll probably need to build up a good amount of equity in your home before you’re able to borrow a large amount of money.

Ultimately, your lender will determine how much you can borrow by looking at a number of different factors.

Similar to when you obtained your original mortgage, lenders evaluate your income, your debt ratios, the value of your home and your credit history.

Determine the type of home equity loan that’s best for you

You will likely have two choices for your home equity loan:

  1. A fixed-rate home equity loan
  2. A variable-rate home equity line of credit (HELOC)

Here’s how the two compare.

Fixed-rate home equity loans

A home equity loan is basically a second mortgage. You take out the total amount you intend to borrow in one lump sum and pay it back every month.

The repayment term for home equity loans is typically 5-15 years. And the payment and interest rate remain the same over the lifetime of the loan.

Also, a home equity loan must be repaid in full if the home is sold.

Adjustable-rate home equity lines of credit (HELOCs)

A home equity line of credit, or HELOC, gives you the ability to borrow up to a certain amount over a certain period of time.

The draw period (typically 5 to 10 years) is followed by a repayment period when draws are no longer allowed (10 to 20 years).  

A HELOC is a revolving line of credit, much like a credit card. You can draw on the available credit as needed, pay it back, and then draw on again, for a term determined by the lender.

HELOCs typically have a variable interest rate, but some lenders may convert to a fixed rate for the repayment period. 

Like a credit card, you can simply pay off the interest every month or pay down the principal as well, depending on your financial needs at the time.

Home equity loans: pros and cons

Home equity loans can be a great way to access the equity in your home without selling it.

Home equity loan pros:

  • If you have a low rate on your current mortgage, you can keep that in place
  • Fixed rates can make budgeting easier thanks to predictable payments
  • Lower interest rates that may be tax-deductible vs. a personal loan or credit card
  • Quicker closing time than for a cash-out refinance

But as with any time you’re borrowing money, a home equity loan may not be the first choice for every homeowner.

Home equity loan cons:

  • Less flexibility than a home equity line of credit (HELOC)
  • You’ll pay interest on the entire loan amount, even if you’re using it incrementally, such as for an ongoing remodeling project
  • Lenders may require slightly higher credit scores than for traditional mortgages
  • Some lenders only offer HELOCs, but not fixed-rate home equity loans

It’s up to you to decide whether a home equity loan or another option — like a cash-out refinance — is best given your situation.

Explore your home equity options (Aug 15th, 2020)

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Home equity loan FAQ

What is home equity?

Home equity is the value of the homeowner’s interest in their home. It is the property’s current market value less any liens that are attached to that property. 

The amount of equity in a home fluctuates over time as payments are made on the mortgage and the value of the property goes up or down.

How do home equity loans work?

A home equity loan is essentially a second mortgage. Your equity in the home serves as collateral for the lender.

Traditional home equity loans have a repayment term, just like regular conventional mortgages. You make regular, fixed payments covering both principal and interest.

As with any mortgage, if the loan is not paid off, the home could be sold to satisfy the remaining debt.

Is a home equity loan a good idea?

A home equity loan can be a good way to convert the equity you’ve built up in your home into cash, especially if you invest that cash in home renovations that increase the value of your home.

But always remember, you’re putting your home on the line: If real estate values decrease, you could end up owing more than your home is worth.

Should you then want to relocate, you might end up losing money on the sale of the home or be unable to move. 

How much can you borrow against the equity in your home?

Homeowners can typically borrow 80–90% of their home’s appraised value using a home equity loan — minus what is owed on their first mortgage. This amount can vary according to your credit score.

Does a home equity loan hurt your credit?

Home equity loans may impact your credit score. However, home equity lines of credit (HELOCs) tend to have a bigger impact on credit scores. Whether the impact is positive or negative typically depends on how much you owe compared to the available credit limit.

What credit score is required for a home equity loan?

Typically, most lenders require a minimum credit score of 620 for a home equity loan. Other lenders may require scores as high as 700. As with other mortgage loans, the better your credit score, the better your interest rate and loan terms.

Are home equity loans tax-deductible?

Home equity loans are currently still tax-deductible. However, there are more limitations than in previous years.

Under the new Tax Cuts and Jobs Act law, you can deduct mortgage-related interest on up to $750,000 worth of qualified loans for married couples filing jointly and $375,000 for separate filers for any home purchased after Dec. 15, 2017.

The deduction amount includes the interest you pay on your mortgage, home equity loan, home equity line of credit (HELOC) or mortgage refinance.

To determine the total amount of interest you might be able to deduct, combine the loan amounts of your primary mortgage, home equity loan, HELOC or second mortgage and make sure it doesn’t exceed one of the maximums above.

If the total is larger than the applicable limits, you’ll only be able to deduct a portion of the paid interest.

Is there a penalty for paying off a home equity loan early?

Most home equity loans do not have a prepayment penalty. However, some HELOC’s do have penalties that are designed to recapture loan closing costs that your lender may have originally waived.

Should you consider a home equity loan?

Approximately 10 million homeowners are expected to get home equity loans through 2022. This would more than double the 4.8 million loans originated in the five-year period of 2012 — 2016.

Whether you need to fix a leaky roof or borrow money for your child’s education, if you have equity in your home, you might consider a home equity loan.

Explore your home equity options with top lenders today.

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