What Is a Home Equity Loan?
A home equity loan is a secured loan that allows a homeowner to borrow against the equity they’ve built up in their property. Equity is accrued through regular mortgage payments and growth in the value of their home.
What does a home equity loan mean for you? It could be a way to cover a big, one-time expense, such as a major home improvement. You could also use a home equity loan to pay off high-interest credit card debt or help fund your child’s college tuition. The possibilities are virtually endless.
However, there are risks involved with home equity loans. It’s important to learn how these loans work and what to expect before applying.
This guide will help you understand the pros and cons of taking out a home equity loan compared to other loan types and provide tips on finding the best home equity lender for you.
Table of Contents
- How does a home equity loan work?
- What is the difference between a home equity loan and a home equity line of credit?
- When is a home equity loan a good idea?
- What not to use a home equity loan for
- Home equity loan requirements
- How to calculate your home equity
- Home equity loan FAQs
How does a home equity loan work?
A home equity loan, often referred to as a second mortgage, works much like a standard mortgage.
Your lender will use your financial profile and the amount of equity you have in your home to determine the loan amount. Once you close, you’ll receive a lump-sum payment of the approved amount, and a second lien will be placed on your home. Depending on the lender, the whole application, approval and disbursement process should take around four to five weeks.
Usually, you’ll need to start repaying the loan back within 30 to 60 days, depending on your closing date. You’ll pay through monthly payments just as you would a first mortgage. The interest rate on home equity loans is typically fixed, so your monthly payments will be constant throughout the loan term. Some lenders may allow you to only pay interest during the loan’s term, then make a balloon payment of the full borrowed amount at the end.
Loan terms can vary between 5 and 30 years, depending on the amount borrowed and the lender. If you sell your home before paying off the loan, the proceeds from the sale will pay both the primary and second mortgages off. However, if your home has decreased in value, you may find yourself underwater and need to pay off the balance at closing.
How much can you borrow with a home equity loan?
You’ll be able to borrow up to 85% of the appraised value of your home minus any outstanding mortgage balance, although some lenders may have slightly lower or higher caps.
An appraisal will determine your home’s fair market value. Multiply that value by the percentage your lender is willing to lend. Then, subtract your outstanding mortgage balance. The result will be the maximum amount of equity you’ll be able to borrow.
For example, your home is appraised at $300,000. Your lender will give you up to 85% of that if you own your home outright. Eighty-five percent of $300,000 is $255,000.
However, you still owe $200,000 on your primary mortgage. Subtract the $200,000 owed and you get $55,000. In this case, $55,00 is the maximum amount a lender will approve for an equity loan.
Costs of a home equity loan
You’ll need to pay closing costs with a home equity loan, which can range from 2% to 5% of the loan amount. These are common fees you should expect to pay, although some lenders may waive certain fees or roll them into the loan. Below are some of the typical closing costs associated with home equity loans.
Appraisal fees
These are the costs associated with having a licensed home appraisal expert come to your home and evaluate the amount it’s worth. Home appraisal fees range from $300 to $500, depending on the size of your home.
Credit report fees
When you apply for a home equity loan, the financial institution you apply with will check your credit report. They may charge between $30 and $50 for this service.
Document preparation and attorney fees
Charges for document preparation and attorney labor will depend on the amount of work that’s needed and the service you hire to do it. Some attorneys charge a flat rate for document preparation and labor for home equity loans. Others charge by the hour.
Origination fees
Home equity loan origination fees are upfront costs charged by the financial institution you use for the loan. These vary by lender and can be either a flat amount or a percentage of your new equity line. Some lenders may be willing to waive your origination fees.
Notary fees
When taking out a new line of credit, you may need to notarize any official documents you complete throughout the process. The price for this can range from $50 to $200 per signature required, or may be charged as a flat fee.
Title search fees
Before completing a home equity loan, most financial institutions will want to search through official title records for the property. The average price for this is between $75 and $100.
Prepayment fees
Some lenders require a prepayment fee if you pay off your loan before the home equity loan term ends. The rate for this fee varies by lender, and is designed to off-set the amount of money the institution loses in interest if you pay off your loan early.
How is a home equity loan repaid?
A home equity loan is repaid just like a primary mortgage. Once you have closed on the loan and received the lump sum payment, you’ll start making monthly payments on the loan.
Your payments will cover both the principal and the interest on the loan and are paid until the debt is paid in full. Because the interest rate is fixed, these payments will be constant throughout the full term of the loan, which can range from 5 to 30 years.
Say you take out a $30,000 home equity loan at a 5.30% interest rate and a five-year term. The monthly payments would be about $570 and your total interest costs would be $4,216. If the term were ten years, the monthly payment would be about $323, and you would pay $8,714 in interest.
Benefits of a home equity loan
A home equity loan can be a good option if you have a clear idea of how to use the money and are confident you can repay it.
Lower interest rates
While the interest rate on a home equity loan is typically higher than the rate on a primary mortgage, it is lower than the rate charged on unsecured debt, such as a personal loan or credit card.
Fixed interest rates
You’ll know exactly what your monthly payments will be throughout the loan term, making this type of loan easy to budget for.
Long payback time
The payback time on a home equity loan can range from 5 to 30 years. The longer the term, the more affordable the monthly payments will be.
Streamline your finances
You can use your home equity loan to consolidate or pay off higher-interest debt, such as credit cards or other unsecured loans.
Pay large expenses over time
You can use a home equity loan to immediately pay large expenses, such as medical bills or home repair costs, but pay back the loan in more comfortable monthly payments over time.
Interest payments may be tax-deductible
If you use the money for home improvements, you may be able to deduct the interest paid on the home equity loan from your taxes. However, if you don’t have enough equity in your home for a home equity loan, there are also home improvement loans designed for this purpose.
Downsides to a home equity loan
Because you're using your home as collateral, there are risks associated with a home equity loan.
Risk of foreclosure
If you run into financial difficulty and can’t afford to make the monthly payments, your lender can foreclose on your home.
Higher credit requirements
While some lenders will accept a credit score in the mid 600’s, many prefer a score over 700. You’ll also have stricter debt-to-income ratio requirements than on a first mortgage. Most lenders prefer a DTI of 36% to 43% although some go as high as 50%, while some first mortgage lenders will accept DTIs as high as 60%.
You need to have enough home equity
You need to have at least 15% to 20% equity in your home in order to qualify.
You’ll need to pay closing costs
The closing costs on a home equity loan generally range between 2% and 5% of the loan amount.
You may get a lower interest rate by refinancing your home
You may be able to find a lower interest rate if you do a cash-out refinance, which basically means you take out a new loan, pay off your old mortgage and receive the difference in a lump sum payment.
How to reduce borrowing risks
Consider all your options before taking out a home equity loan. Talk to a financial advisor or attorney to make sure you understand all the risks involved in using your home as collateral.
Have a clear idea of how much money you need. The lender may approve a higher amount, but you should only borrow enough to cover the expenses you want to pay. This will keep your monthly payments lower and keep you from spending more than necessary.
Finally, make sure you read through and understand all the loan documents. Confirm they are the same terms you agreed to before signing.
Watching out for dishonest lenders
The Federal Trade Commission warns that some lenders specifically target older homeowners and those with modest means or bad credit for schemes involving home equity loans. When successful, these schemes can result in the homeowner facing severe financial hardship and the loss of their home.
The following practices are warning signs that you’re dealing with a dishonest lender:
- You are pressured into borrowing more money than you need
- The lender wants you to get a loan with monthly payments higher than you can comfortably afford
- You’re asked to lie on your application — for example, stating you have a higher income than you actually earn
- You are asked to sign blank documents
- The lender claims you can’t have copies of the loan documents — you can and should have copies
- The lender says you shouldn’t read the loan disclosures, or you don’t need to have them. The law requires the lender to provide them, and you should read and understand them thoroughly before signing
- The lender offers one set of terms then changes them at the closing without explanation or your agreement
Remember to report dishonest lending practices to the Consumer Financial Protection Bureau (CFPB). You can also use the site to look up information about lenders to screen for reported violations.
What is the difference between a home equity loan and a home equity line of credit?
A home equity loan is a secured loan that uses the equity in your home as collateral and functions as a second mortgage. Once approved, you receive a lump-sum payment of the loan amount, which many people use to pay for large one-time expenses. The repayment period begins once you’ve received the funds and the interest rate is fixed, which makes for predictable monthly payments.
A home equity line of credit also uses the equity in your home as collateral. However, it works more like a credit card in that you can withdraw money from the line as needed. You’ll make interest-only payments on the withdrawn amount during what is known as the “draw” period and can repay the drawn amount to replenish it and reuse the money.
Once the draw period ends, the loan enters the repayment period. You’ll start repaying the principal on any outstanding balance plus interest and won’t be able to draw any more money. The rate on HELOCs is usually variable, so your monthly payments will change periodically.
When is a home equity loan a good idea?
A home equity loan can be a good option if you know you have a large expense coming up and you want to be able to pay it outright. Here are some of the more common uses for this type of loan.
Making home improvements
Refinishing or installing new flooring, upgrading a kitchen or refreshing a bathroom will not only make your home more livable but will also add to its resale value if you decide to sell. Plus, the interest you pay on a loan for home renovations could be tax-deductible.
Paying off higher interest debt
Use the loan to pay off or consolidate higher-interest debts like credit cards into one comfortable monthly payment. You could also pay down other loans, such as personal loans, if the interest rate on the equity loan is lower.
Education
Defray the costs of a child’s college education or fund your own return to school to get a specialty or advanced degree. Or you can pay off student loans that have a higher interest rate.
Pay for emergency expenses
An emergency can happen at any time. A home equity loan can be used to pay for unplanned expenses, such as home repairs or a medical emergency.
What not to use a home equity loan for
Taking out an equity loan on an existing mortgage can be an effective financial strategy in certain situations. But it also reduces your future loan options and will increase the amount of time it takes to pay off your home. Because of these risks, you shouldn’t increase your home credit line for any of the following reasons.
Paying off debt without a plan
In some situations, it could make sense to use a home equity loan to consolidate debt. For example, home equity loan funds could help if your current annual percentage rate on the debt is significantly higher than what you’d pay in interest for the home equity line, or if you want to switch from a variable interest rate to a fixed prime rate.
However, you shouldn’t consolidate debt with a home equity loan without a plan. If you’re not taking steps to reduce your debt, you could fall behind on your loan payments — which could ultimately result in the foreclosure of your home.
To spend more than you can afford
Home equity lines can provide a major influx of cash, but it’s important to remember this is still money you will need to pay back eventually. It’s unwise to use this type of credit to purchase expensive cars, go on fancy vacations and support a lifestyle that is beyond your means.
Remember, if you fail to meet the repayment terms on a real estate line of credit by missing payment installments, your house could be at risk. That’s only a risk you should assume with your money if you have a firm plan in place for paying the funds back in a timely manner.
Paying for advanced education
Using an equity loan for your higher education expenses may seem like a good idea. However, this is a risky strategy, even if the home equity interest rate offer you receive from your credit union is better than the rate available for student loans.
This is because federal student loans have more repayment options than traditional loans. Depending on your loan options, you will likely be able to choose from a variety of income-based repayment plans. And you may even be eligible for public service loan forgiveness if you work in a qualifying job after graduation.
Investing
Finally, using your money from a home credit line for investing is also unwise. Any investment you make with the funds you receive would have to outperform the interest rate on the loan to be successful. To do this, you would have to assume risk, which could backfire and cost you your home.
Investing is a proven method for increasing wealth. But it’s also inherently risky and should not be done in a way that puts one of your most important assets — your home — at risk.
Home equity loan requirements
The requirements for getting a home equity loan vary by lender, but in general, you should expect to be able to meet the following:
Have enough equity in your home
You need to have at least 15% to 20% equity in your home to qualify. To find out how much equity you have in your home, you can calculate your loan-to-value ratio (LTV) by dividing your current mortgage balance by your home’s appraisal value.
For example, if your home is appraised at $400,000 and your outstanding mortgage is $230,000, your LTV (or your equity) would be about 58% (230/400 = .575 x 100 = 57.5%) and your equity would be 42%.
Have a good credit score
Some lenders will approve borrowers for home equity loans with credit scores as low as the mid-600s. However, most will require a credit score of 700 or more.
Have a low debt-to-income ratio
Your debt-to-income ratio (DTI) should be 43% or less, although some lenders may accept a DTI as high as 50%. This number represents how much of your gross monthly income goes towards paying expenses and gives the lender an idea of how big a loan you can afford to pay.
Have proof of income
Depending on the lender, you may be required to present W-2s, pay stubs, bank statements or some other form of income verification. As you shop for a lender, be sure to ask about what documents you’ll need and have them ready when you apply.
Have a history of on-time payments
Demonstrating a history of on-time payments shows your lender that you are likely to make your monthly payments as agreed. However, a history of missed or late payments could result in a higher interest rate or a loan denial.
How to calculate your home equity
If you believe a home equity loan is right for you, the next step will be calculating how much equity you have in your home credit limit you can take out.
Follow this formula:
- Find out the total appraised value of your home
- Subtract the full amount of any loans that are currently secured by the house
- The resulting number will be the amount of home equity you have
However, just because you have a certain amount of home equity doesn’t necessarily mean a bank will give a loan up to that amount. Financial institutions may offer less than your home equity amount if you have high amounts of debt elsewhere.
It’s also worth considering whether taking out the full amount you’re offered is a good idea. Doing so will significantly reduce your ability to take out future loans that are backed by your home. That may lead to unexpected problems in the future, as it’s always possible that your financial situation will change.
Bottom line to home equity loans
A home equity loan can be a good option if you need cash to pay for home improvements, medical expenses or pay off high-interest credit card debt. You’ll receive the funds as a lump-sum payment and you’ll pay a fixed interest rate on the loan.
However, risk is involved: A home equity loan is secured using your home as collateral, and defaulting on your loan could result in foreclosure. Before taking out a home equity loan, be sure you fully understand the terms and conditions, and carefully consider your ability to repay.