How does a home equity loan work? Overview and process

Fund financial goals with a home equity loan

A home equity loan lets you turn your home's value into cash. 

Banks can offer a lump sum of money, secured by your home's value, that you pay off in fixed installments over a set period of time. A home equity loan works a lot like a mortgage, but instead of using it to purchase or refinance a house, you use it to borrow cash from your property.

If you're considering a home equity loan, here's what you should know about the process, rules, and requirements to qualify.

In this article (Skip to...)

• What is a home equity loan?
• How it works
• How much you can borrow
• Rates
• Requirements
• Pros and cons
• Loan application process
• FAQ

What is a home equity loan?

Sometimes referred to as a "second mortgage," a home equity loan is a type of financing that lets homeowners borrow against the equity available in their home. Equity is the difference between the amount you owe on your existing mortgage loan and your home’s current value.

The funds from a home equity loan can be used for nearly anything. Many homeowners use a home equity loan to pay for home renovations and repairs, outstanding medical bills, college tuition, or a significant event like a wedding. Others use the money to consolidate higher-interest debt.

Depending on the lender and loan, you may not be allowed to use home equity loan funds for a few specific purposes. “There are some restrictions on how the funds can be used. For example, they often cannot be used to purchase a second home or investment property,” says Boyd Rudy, associate broker with Dwellings Michigan.

How does a home equity loan work?

With a home equity loan, your primary residence is used to secure the loan. If approved, you can borrow from the equity your home has accrued. That includes any of the home's value you've paid off over time as well as the equity you've gained through rising home prices.

Home equity loans work a lot like primary mortgage loans. They typically have fixed interest rates and a set repayment term (often between five and 30 years). After the loan closes, you receive a one-time lump sum of cash and pay it off in equal monthly payments to your lender. If you have an existing mortgage on the home, your home equity loan will be a second, separate payment on top of your current mortgage payment.

Many mortgage lenders, banks, credit unions, and other financial institutions offer home equity loans.

What can I do with a home equity loan?

You have quite a bit of flexibility when it comes to using a home equity loan, as most lenders don't place restrictions on how you can spend the funds. Many people use home equity loans for debt consolidation, especially for high-interest credit card debt or other types of loans. They're also commonly used for home improvements and upgrades, which can add value to your property.

If you have education expenses or medical debts, a home equity loan can help cover those as well. Some homeowners even use the funds to start a business or buy an investment property. Essentially, you can use a home equity loan for any major purchase or financial need you may have.

How much can I borrow with a home equity loan?

The rule of thumb with most home equity loans is that you can borrow up to 80% or 85% of your home’s value, minus your existing mortgage balance.

"Let’s say your home is worth $300,000 and you have earned $100,000 in equity," says Dennis Shirshikov, a strategist for Awning.com and a professor of economics and finance for City University of New York. He explains:

• Assume the lender will allow you to borrow up to 80% of your home’s value
• Eighty percent of $300,000 is $240,000
• Next, you subtract the mortgage balance you owe, which is $200,000
• $240,000 minus $200,000 equals $40,000
• That means you can take out a home equity loan for up to $40,000 in this scenario

Other factors that determine how much you can borrow using a home equity loan include your credit score, current interest rates, and your debt-to-income ratio (which measures your existing monthly debts against your monthly income).

Home equity loan rates

Home equity loan rates are commonly tied to an industry standard known as the prime rate, which serves as the lowest interest rate lenders offer to their most creditworthy customers. Lenders typically add an additional percentage, known as a margin, to this rate. 

For example, if the prime rate is 6.5% and a lender adds a margin of 1.2%, the final home equity loan rate would be 7.7%.

The margin can differ from one lender to another, making it advisable to obtain multiple quotes. Additionally, individuals with higher credit scores and lower debt-to-income ratios are generally more likely to secure favorable rates.

Home equity loan requirements

Different lenders can have different home equity loan requirements. But many have similar basic guidelines.

Typical home equity loan requirements:

• You must have more than 20% equity built up in your home
• You must meet a minimum credit score, often 620 or higher
• You must have a debt-to-income ratio at or below 43%
• You must demonstrate sufficient earnings and good job security by providing pay stubs, W-2s, tax returns, financial statements, and other documentation the lender requests

"In some cases, you may also have to wait at least a year after closing on your primary mortgage loan before you can pursue a home equity loan," notes Shirshikov. This is called "loan seasoning." Not all lenders have a seasoning requirement, so shop around and ask about different lenders' policies if you just recently purchased your home.

How to get a home equity loan

Taking out a home equity loan is similar to the process for getting a standard mortgage loan.

First, you should decide what you need the funds for and how much you want to borrow. You might learn that you're approved to borrow more than you really need, and having a number already in mind can help you avoid overborrowing and paying more on interest and fees than necessary.

Next, you're ready to shop and apply for a home equity loan.

1. Get home equity loan estimates from a few lenders to compare rates, terms, and fees
2. Once you decide on a loan originator, submit a full loan application online or in person
3. Provide requested financial documentation like proof of homeownership, paystubs, W-2 forms, and tax returns
4. Your lender orders a home appraisal to determine your home's value and the amount of equity available to borrow
5. You wait for final approval from the underwriter

Once your home equity loan application is approved, you'll sign the closing papers and receive the funds as a lump sum. The full home equity loan process, from application to receiving funds, can take as little as two weeks for well-prepared homeowners.

Pros and cons of a home equity loan

Understanding the pros and cons of home equity loans is necessary before taking one out. Finding the best option for your personal finances requires balancing the advantages over the disadvantages.

Pros of home equity loans

Laura Sterling, vice president of marketing for Georgia’s Own Credit Union, says that a home equity loan offers several advantages over other types of financing.

"Because your property secures the loan, interest rates are often much lower than you would pay on a personal loan or credit card. [And] while you may pay closing costs or other fees, it’s an inexpensive alternative to an unsecured loan," she says. "The interest you will pay may also be tax-deductible up to $100,000 if used for home renovations on the home for which the loan is secured, although it’s best to consult your tax advisor for eligibility."

• Easier qualification: Compared to other loan types, home equity loans are often easier to qualify for, especially if you have a good amount of equity in your home
• Lower interest rates: These loans usually come with fixed interest rates that are lower than those for other types of consumer loans, making them more affordable in the long run
• Longer terms: Home equity loans often have longer repayment terms, giving you more time to pay back the loan
• No usage restrictions: One of the best things about home equity loans is that there are no limitations on how you can use the funds. Whether it's for home improvements, debt consolidation, or even a vacation, the choice is yours
• Immediate access to funds: Once approved, you'll receive the funds as a lump sum, allowing you immediate access to the money you need
• Predictable payments: Because the interest rate is usually fixed, you’ll benefit from fixed monthly payments, making it easier to budget

Additionally, unlike most loans, the repayment terms on home equity loans usually range from 10 to 20 years or longer. That equates to more affordable monthly payments than other types of financing.

Cons of home equity loans

But home equity loans aren't without risk.

"Because your home secures the loan, if you fail to pay the home equity loan, your financial institution could foreclose on your home," Sterling cautions. "Similarly, if your home’s value declines, you could end up owing more on your home than it is worth — making it hard to sell."

• Second mortgage: One of the biggest downsides is that you'll have another mortgage to worry about. You'll be making payments on this loan in addition to your primary mortgage.
• Foreclosure risk: Because your home serves as collateral for the loan, you run the risk of losing it if you default on it.
• Must pay off when selling: If you decide to sell your home, you'll need to pay off the entire balance of the home equity loan, along with any remaining balance on your primary mortgage, at the time of the sale.
• Closing costs: Unlike some other types of loans, you'll have to pay closing costs, which can add to the overall cost of borrowing. 

Furthermore, you are responsible for the loan balance if you sell your home. You will have to repay your home equity loan, which typically means using the proceeds of your home sale to pay off both the primary mortgage loan and the home equity loan.

"Another disadvantage of using a home equity loan is upfront costs. These loans come with closing costs and fees ranging from 2-5% percent of the loan," Sterling adds.

What are the alternatives to home equity loans?

If you're contemplating a home equity loan to tap into your home's value, it's important to know that you have other options. Two popular alternatives are home equity lines of credit (HELOCs) and cash-out refinance loans. Each has its own qualifying criteria and unique features that can either make or break your financial plans.

Home equity line of credit (HELOC)

A HELOC offers flexibility that a home equity loan doesn't. Unlike a home equity loan, which gives you a lump sum payment upfront, a HELOC acts more like a credit card with a revolving credit limit based on your home's current market value and your credit history. 

You have a set limit that you can draw from as needed, typically over a 10-year draw period. This makes it ideal for ongoing expenses like remodels and upgrades to your real estate property.

HELOCs usually come with variable interest rates, which can be both a boon and a bane depending on the market conditions. Your DTI ratio and credit history will play a role in qualifying for a HELOC, and bad credit may result in higher interest rates. 

During a HELOC’s draw period, you're generally required to pay interest only on the amount you've borrowed. Once this ends, you'll enter a repayment period that can last up to 20 years, during which you'll pay back both the principal and interest. 

Cash-out refinancing

A cash-out refinance is another alternative that allows you to leverage the value of your home. Unlike a home equity loan, which acts as a second mortgage, a cash-out refinance replaces your existing mortgage with a new one. The new mortgage is for a higher amount than your current loan, and the difference is disbursed to you in a lump sum of cash. Those looking to secure a lower rate on their loan payments frequently choose this option. 

Cash-out refinance loans often come with interest rates that are more comparable to standard mortgage rates, which are usually lower than those for home equity loans. This makes them an attractive option for those looking to secure a lower rate while also accessing cash. 

The loan term for a cash-out refinance can range between 5 and 30 years, offering you considerable flexibility in your repayment schedule.

Whether you opt for the flexibility of a HELOC or a new mortgage offered by a cash-out refinance, understanding these options will help you make the most of your home's equity.

FAQ: How does a home equity loan work

Find out if you're eligible for a home equity loan

So there you have it! Understanding how a home equity loan works isn't just financial jargon; it's about unlocking the value you've built up in your home. Think of it as your house giving back to you—whether that's helping you consolidate debt, finance home improvements, or cover emergency expenses.

But remember, a home equity loan is a big commitment that comes with its share of risks and rewards. Do your homework, weigh the pros and cons, and most importantly, find a lender that has your best interests at heart.

Curious about how much you can borrow? Want to get the ball rolling? Click the links below to find out your current loan eligibility from multiple lenders and get closer to making your financial goals a reality.