What is a home equity loan? Simple home equity loan guide

Valencia Higuera
Valencia Higuera
The Mortgage Reports Contributor
August 1, 2022 - 9 min read

What is a home equity loan?

A home equity loan is a type of loan that lets you borrow against your home’s cash value, often at a low fixed interest rate.

As a “second mortgage,” a home equity loan is typically a smaller, second loan taken out in addition to your main mortgage. This lets you tap your home’s value without changing the rate or terms on your main mortgage. You can also take out a home equity loan if your home is fully paid off and borrow only the amount you want to cash out.

A home equity loan is one of the best ways to unlock your home’s equity without selling or refinancing the property.

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Home equity loan definition

A home equity loan is a type of mortgage that’s secured by your home equity. Equity is the difference between your home’s value and what you owe the mortgage company. If you owe your mortgage lender $100,000 and your property appraises for $250,000, you have $150,000 in equity.

Unlike a cash-out refinance, a home equity loan is used for the sole purpose of borrowing cash. It does not refinance your existing mortgage balance or change the rate and term on your primary mortgage. Rather, it’s a separate loan with its own interest rate and monthly payment. That’s why a home equity loan is known as a “second mortgage.”

Smart uses for a home equity loan include debt consolidation, home improvements, paying for college, and starting a business. These types of loans aren’t typically recommended for luxury items, vacations, or risky investments.

How home equity loans work

A home equity loan is a lump sum installment loan, meaning you’ll receive the entire loan amount upfront and pay it off in equal monthly installments until the balance is zeroed out.

Home equity loans work a lot like standard mortgages. They typically have fixed rates and fixed monthly payments, with loan terms ranging from five to 30 years. You can deduct interest paid on a home equity loan, but only when using funds to buy or build a property or “substantially improve” a property you already own.

Home equity loans differ from home equity lines of credit (HELOCs), which allow borrowers to access a line of credit on an as-needed basis. They’re also different from cash-out refinancing, which replaces an existing mortgage with a new one.

Since you’re taking another loan against the property, home equity loans are also known as second mortgages. Your primary mortgage remains as the “first lien,” and your second mortgage is the “junior lien.” If you sell the home before repaying a home equity loan, you’ll pay off the balance with proceeds from the sale.

Home equity loans are attractive because they typically have lower interest rates compared to other types of debt like credit cards and personal loans. But since your home acts as collateral, missing loan payments could result in foreclosure.

How much of a home equity loan can I get?

The amount you can borrow with a home equity loan depends on how much equity you’ve built up in your home and what you own on your primary mortgage. Most lenders cap your combined loan-to-value ratio (CLTV) around 80%, meaning your primary mortgage and your home equity loan together can’t be more than 80% of the home’s value.

For example, say your home appraises for $400,000 and you currently owe $150,000 on your primary mortgage. Here’s how to find your maximum home equity loan amount:

  • Home value: $400,000
  • Maximum combined loan amount: $320,000 (80% of value)
  • Existing mortgage balance: $150,000
  • Maximum home equity loan: $170,000 (maximum CLTV minus existing mortgage)

The amount you can borrow also depends on your credit score, interest rate, and debt-to-income ratio (DTI).

When it comes to DTI, your lender will review your monthly loan and credit card payments and then compare this figure with your income to determine affordability. For this reason, two borrowers with similar incomes and the same amount of equity can qualify for different size home equity loans — especially if one borrower has more debt than the other.

Requirements for a home equity loan

Just having a lot of equity doesn’t necessarily qualify someone for a second mortgage. Home equity loan requirements differ from one lender to the next, but typically include:

  • More than 20% equity in the home
  • A debt-to-income ratio of 43% or lower
  • Meet the lender’s minimum credit score requirement
  • Proof of income or an ability to repay

Credit score requirements for a home equity loan vary heavily by lender. Some lenders allow credit scores as low as 620, whereas others require a score in the mid-600s or higher.

If you have a lower score, you’ll need to shop around and compare lenders. It might be easier to qualify if you have compensating factors, such as low debts or extensive assets.

How to get a home equity loan

Here are seven steps to apply for a home equity loan:

1. Review your finances

A home equity loan adds to your monthly debt, so review your finances to see if you can handle the additional payment. Also, review your credit report and credit score. You typically need a minimum 620 credit score to qualify. Paying your bills on time, paying down credit cards, and disputing errors on your credit report can raise your score.

2. Determine how much to borrow

Your lender ultimately decides how much you can borrow from your equity. Even so, have a figure in mind so that you don’t borrow more than necessary. Think about how much cash you need to accomplish your financial goals and what monthly payment you’re comfortable with — especially if you’re still paying down your first mortgage.

3. Gather your paperwork

You’ll need to submit supporting documentation such as paycheck stubs, tax returns, W-2s, and bank statements. Lenders use this information to calculate your debt-to-income ratio and affordability. Having your paperwork ready to go ahead of time will help your application get approved more quickly.

4. Compare home equity loan lenders

Home equity loan requirements and terms can vary by lender. Get a minimum of three quotes from different lenders and then compare rates, terms, and credit score requirements. You can get a quote from your current lender as well as other banks, credit unions, mortgage companies, and online lenders.

5. Go through the underwriting process

Your lender will carefully review your income statements, bank statements, credit history, and debts to see if you qualify for a home equity loan and determine how much you can borrow.

6. Wait for the appraisal

Your mortgage lender will order a home appraisal to assess your home’s value. This is required before approving your application.

7. Close on the loan

Once your lender completes the underwriting process and receives the appraisal report, the final step is closing. You’ll sign the loan paperwork and receive the lump sum payment.

After closing on a home equity loan, you’ll begin making regular monthly payments. If you currently have a mortgage loan, your home equity loan will be a second payment on top of your regular mortgage payment. If your home was paid off, you’ll pay only the home equity loan.

Home equity loan FAQ

Is a home equity loan a mortgage?

A home equity loan is a type of mortgage loan. It isn’t a primary mortgage, like the one you use to buy a home, but rather a secondary mortgage secured by the property. This junior lien is also called a second mortgage. Since your property serves as collateral for a home equity loan, not repaying the loan could result in foreclosure.

How long does it take to get a home equity loan?

On average, it can take between two weeks and six weeks to close on a home equity loan. The process of getting a home equity loan can vary from lender to lender. Factors that influence the timeline include a lender’s underwriting process, appraiser schedules, scheduling conflicts, and delays with submitting documentation.

What are average home equity loan rates?

Home equity loan rates are usually a little higher than standard mortgage loan rates. However, they tend to be substantially lower than other, unsecured forms of borrowing like credit cards and personal loans. Home equity loan rates are fixed, meaning your interest rate and payment will stay the same throughout the loan term.

Is a home equity loan tax-deductible?

Home equity loans are only tax-deductible under special circumstances. Currently, you can deduct interest on a home equity loan only when using the funds to buy or build a primary residence or second home, or when using funds to substantially improve a primary residence or second home. As of 2022, married couples filing jointly can deduct interest on up to $750,000 of mortgage debt, and married couples filing separately can deduct interest on up to $375,000 of mortgage debt.

Can you get a home equity loan with bad credit?

Most lenders require a minimum credit score in the mid- to high-600s for a home equity loan, but it may be possible to get approved with a lower score. Some lenders will approve homeowners with scores as low as 620. However, you’ll need to shop around to find these lenders. It’s easier to get approved with bad credit when you have compensating factors. This includes stable income and little consumer debt.

What lenders do home equity loans?

Home equity loans are widely available, and many types of lenders offer this option. These include banks, credit unions, mortgage companies, and online lenders. To get started, contact your current mortgage lender and your bank or credit union. Compare their rates, terms, and requirements. Get at least three rate quotes before choosing a lender.