Learn how home equity loans work
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
- Requirements
- Pros and cons
- Steps to get one
- Home equity loan 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 a home equity loan works
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.
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 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 tha 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 paystubs, 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.
Pros and cons of a home equity loan
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.”
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.
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.”
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.
Steps 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 over-borrowing and paying more on interest and fees than necessary.
Next, you’re ready to shop and apply for a home equity loan.
- Get home equity loan estimates from a few lenders to compare rates, terms, and fees
- Once you decide on a lender, submit a full loan application online or in person
- Provide requested financial documentation like proof of homeownership, paystubs, W-2 forms, and tax returns
- You lender orders a home appraisal to determine your home’s value and the amount of equity available to borrow
- You wait for final approval from the underwriter
Once your home equity loan application is approved, you’ll sign 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.
Home equity loan FAQ
A home equity loan is a loan you take out from a bank that’s secured by your home’s value (meaning your lender could repossess the home if you don’t make your payments). With a home equity loan, you get a one-time lump sum of cash at closing and pay it off in equal monthly installments over the life of the loan. If you currently have a mortgage on your house, the home equity loan would create a second, separate payment. If your home is paid off, the home equity loan would be your only monthly mortgage payment.
Tapping into your home’s equity can be a smart way to secure financing, so long as you have earned sufficient equity and qualify for a home equity loan. Many experts agree that the best use of home equity funds is to reinvest in your property by making home improvements that can potentially increase your home’s value. Home equity loans also charge a lower interest rate than other, unsecured types of financing, including personal loans and credit cards.
A home equity loan is a type of mortgage known as a second mortgage. A second mortgage is not used to buy or refinance a property. Rather, it lets you borrow from the equity accrued in your existing home using a secured loan at a low interest rate.
Many lenders require you to wait at least one year after closing on a primary mortgage loan before you can be approved for a home equity loan. This is referred to as loan seasoning. Some lenders bypass the seasoning rule, however. So if you recently bought your home and want a home equity loan, talk to a few lenders and ask about their policies. You are not required to use your existing lender for your home equity loan.
One downside of a home equity loan is that you have to pay upfront closing costs, often totaling two to five percent of your loan amount. In addition, home equity loan rates are higher than mortgage rates (although since you’re only borrowing equity, and not refinancing the entire home value, loan amounts and monthly payments are usually lower). In addition, a home equity loan is secured by your home’s value. That means if you can’t make payments, you could face foreclosure. Finally, there can be a risk of owing more on your home than it is worth if the property value falls. However, with home values rising and demand still strong across most of the country, this scenario seems unlikely for most homeowners.
A home equity loan can often offer a large sum of cash at a low interest rate. If you need to borrow a substantial amount of money for something like home improvements, a home equity loan can be an affordable way to do it. In addition, a home equity loan does not affect your existing mortgage — unlike a cash-out refinance. That means if you have a low rate on your existing loan and don’t want to refinance, you can keep that low rate in place and pay a higher rate only on what you borrow from your equity.
