A home equity loan is a secured loan that allows a homeowner to borrow against the equity they’ve built up in their property through regular mortgage payments and growth in the value of their home.
A home equity loan can be a relatively low-cost option for covering a big one-time expense. However, there are risks involved, so 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.
- 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?
- Home equity loan requirements
- Home equity loan FAQ
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 normally fixed, so your monthly payments will be constant throughout the loan term. Some lenders may allow interest-only payments during the loan’s term and require 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:
Appraisal fees — average between $300 to $500
Credit report fees — average between $30 to $50
Document preparation and attorney fees — costs vary and may be charged per hour or as a flat fee
Origination fees — vary by lender and may be waived
Notary fees — average between $50 to $200 per required signature or may be charged as a flat fee
Title search fees — average between $75 to $100
Prepayment fees — vary by lender
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.
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
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 the loan 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.
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. An equity loan can be used to pay for unplanned expenses such as home repairs or a medical emergency.
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.
Home equity loan FAQs
How does a home equity loan work?
What is a HELOC loan?
Are home equity loans tax deductible?
How much home equity loan can I get?
What is the interest rate on a home equity loan?
How do you get a home equity loan?
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 higher-interest debt like a credit card. Also known as a second mortgage, a home equity loan is secured using your home as collateral.
You’ll receive the funds as a lump sum payment and you’ll pay a fixed interest rate on the loan. Before taking out a home equity loan, be sure you fully understand the terms and conditions. Be aware of the risks associated with a home equity loan, which include the potential of losing your home if you can’t pay.