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What is a home equity loan? A complete overview

Of all the differences between owning a home and renting one, the opportunity homeowners have to build equity in their homes may be the most significant.

Through a combination of market appreciation and years of mortgage payments, you could end up acquiring a substantial amount of equity in your home. You can cash out this equity when you sell the house or borrow against it to cover other expenses while you own it. One of the most popular ways to tap into your home equity is to get a home equity loan.

Learn more: How to buy a second home

What is a home equity loan?

A home equity loan allows you to borrow money by using the equity in your home as collateral. A home equity loan is considered a type of "second mortgage" because you take it on in addition to your existing mortgage — unlike a mortgage refinance, which involves replacing your original mortgage with a new one. This second loan gives you a lump sum of cash you can use for home improvements or other purposes.

How does a home equity loan work?

A home equity loan typically has a fixed interest rate, a fixed term — also known as a repayment period — and a fixed monthly payment that won't change during your term. Repayment periods can range from five years to 30 years.

Home equity loans usually have lower interest rates than other types of debt, such as credit cards. That's because the home equity loan is secured — the technical term is "collateralized" — by your home. If you're unable to make monthly payments, your lender may foreclose on your home.

Learn more: How does a fixed-rate mortgage work?

How much can you borrow with a home equity loan?

The amount you can borrow with a home equity loan depends on your income, your credit history, and how much equity you have in the home, among other factors. Most mortgage lenders limit the loan amount to 80% of your home's equity.

There are a few ways to calculate how much you can borrow. One way is to take 80% of your home value, then subtract how much you still owe on your house. The remaining balance is the amount a lender might let you borrow.

For example, if your home was worth $400,000, 80% of that amount would be $320,000. If you still owed $200,000 on your primary mortgage, your home equity loan limit would be $120,000 ($320,000 - $200,000 = $120,000).

If your equity is low or negative, you'll need to wait until the market value of your home increases or you pay off more of your primary mortgage principal before you apply for a home equity loan.

Home equity loan requirements

As with your original mortgage, you must meet certain requirements to be eligible for a home equity loan. To get a home equity loan, you must have at least 20% equity in your home (which is another way of saying your loan-to-value ratio should be 80% or lower). You'll schedule a home appraisal so home equity loan lender can see how much your home is worth and the amount of equity you have in the house.

Most mortgage lenders require a 680 credit score and 43% debt-to-income ratio (DTI) — however, every lender is different. You'll have to provide documentation such as pay stubs and tax records when you apply.

Read more: Discover home equity review 2024

Can I use my home equity loan for purposes other than home improvements?

Homeowners can use home equity loans for a variety of purposes, such as consolidating credit card debt, making home repairs or improvements, buying a car, or financing a child's education. Other uses may include traveling, starting a small business, paying medical bills, investing, or setting up an emergency savings fund. Basically, you can use money from a home equity loan however you see fit.

However, you may want to be cautious if you plan to use your home equity loan to consolidate debt or invest in other assets. Other types of debt, such as credit card bills, may charge higher interest rates than a home equity loan, but you won't lose your home if you can't make your card payment. Also, if you invest and lose money, you could have trouble affording your home equity loan payments. Regardless of how you spend the money, weigh the pros and cons to decide whether it’s worth taking out a home equity loan.

If you use a home equity loan to make improvements to your home, you could recoup part of the cost of your loan when you sell the house.

Interest paid for a home equity loan may be deductible when you file your income tax returns if you use the funds to buy, build, or significantly improve a first or second home that secures the loan.

Pros and cons of a home equity loan

Pros

  • Receiving your money in one lump sum is helpful if you have a large expense

  • You can use the money however you see fit, from home improvements to college tuition to paying off debt

  • A fixed interest rate means your monthly payments won't change

  • Interest paid on a home equity loan could be tax deductible

Cons

  • Your home is collateral for the loan, which means you could face foreclosure if you fail to make payments

  • You'll pay closing costs

  • You must meet qualification requirements including your credit score, loan-to-value (LTV) ratio, debt-to-income (DTI) ratio, and more

Alternatives to a home equity loan

Home equity loans aren't free. Like primary mortgages, these second loans involve a variety of upfront fees and expenses in addition to monthly interest charges. These costs might include document preparation fees, recording fees, escrow costs, and attorney's fees, among others. The wide variety of fees is one reason you should shop around and compare loan offers before saying yes to a home equity loan.

Not sure if a home equity loan is right for you? There are several other options for tapping into the equity in your home.

Cash-out refinance

A cash-out refinance is a new mortgage that pays off your existing primary mortgage and gives you an additional lump sum in cash. Your new mortgage will have a higher balance than your original one.

Learn more: Cash-out refinance vs. home equity loan

Home equity line of credit (HELOC)

A HELOC is a revolving credit line that's secured by the equity you have in your home. Like a credit card, a HELOC allows you to borrow up to your credit limit and then repay — and reborrow — funds when you choose. HELOCs typically have a variable interest rate.

Dig deeper: Home equity line of credit (HELOC) vs. home equity loan

Personal loan

A personal loan or line of credit may be either unsecured or secured by assets other than your home or car. Personal loan term lengths and interest rates vary depending on the lender and your financial situation.

Dig deeper: Home equity loan vs. personal loan — Which is best for home improvement?

HECM

A home equity conversion mortgage (HECM) is a special type of home loan intended for older homeowners who need to access their equity. Repayment isn't required until the homeowner sells the house, moves out, or dies. HECMs are also known as "reverse mortgages."

If a home equity loan sounds like a good fit for your needs, talk with a lender to find out how you can apply. Ask the lender how much equity you'll need, how much you’ll be allowed to borrow, what interest rate you might be offered, and what other requirements you must meet for approval.

Home equity loan FAQs

What is the downside to a home equity loan?

The main downsides to a home equity loan have to do with interest. Home equity loans usually charge higher interest rates than home equity lines of credit, and you must pay interest on the entire loan amount. With a HELOC, you take out money on a rotating basis as you need it, so you might not end up borrowing as much as you expected. But a home equity loan requires you to borrow money in one lump sum, so you'll pay interest on that full amount regardless of whether you use it.

Is it hard to get a home equity loan?

Getting a home equity loan is relatively easy, as long as you have enough equity in your house to qualify and your finances are strong.

What is the monthly payment on a $50,000 home equity loan?

It depends on your interest rate and term length. The monthly payment on a $50,000 home equity loan with an 8% rate and 10-year term would be roughly $600.

What is the monthly payment on a $100,000 home equity loan?

Your monthly payment will depend on factors such as your term length and interest rate. On a $100,000 home equity loan with an 8% rate and a 10-year term, your monthly payment would be about $1,200.

Do you have to pay back a home equity loan?

Yes, you have to pay back a home equity loan. These loans have "repayment periods," which can last from five to 30 years. You'll repay the loan in fixed monthly installments.

Are home equity loans tax deductible?

Interest paid on a home equity loan may be tax deductible if you follow certain rules, such as using the money for home renovations.

How do I qualify for a home equity loan?

To qualify for a home equity loan, you'll likely need an LTV ratio of 80% or less, a DTI ratio of 43% or less, and a minimum credit score of 680. Each lender has different requirements, though.

What are the typical term lengths and interest rates for a home equity loan?

Home equity loan repayment terms typically lasts between five and 30 years. Your home equity loan interest rate depends on your term length and personal finances, but you can probably expect to pay roughly 8.50% to 10.25% right now.