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Of all the differences between owning a home and renting one, the opportunity homeowners have to build equity may be the most significant.
Through a combination of market appreciation and years of making mortgage payments, homeowners often end up acquiring a substantial amount of equity in their homes. And that equity equals profit when it comes time to sell the property.
You can also borrow against your equity to cover renovations, repairs, credit card debt, or other expenses while you still live there. And a home equity loan? This is one of the most popular ways to do it.
Learn more: 7 ways to build equity in your home
In this article:
What is a home equity loan?
A home equity loan allows you to borrow money by using the equity in your home as collateral.
It’s considered a type of "second mortgage" because you take it on in addition to your primary 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. You then repay the money back, plus interest, over an extended period of time.
Dig deeper: What to know about second mortgages
How does a home equity loan work?
A home equity loan typically has a fixed interest rate, a fixed term, and a fixed monthly payment that won't change during your term. Home equity loan terms can range from five to 30 years, depending on the lender.
Interest rates for home equity loans are often lower than rates for 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. It’s also why if you're unable to make monthly payments, your lender may foreclose on your home.
Read more: The best home equity loan lenders
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 home equity loan lenders limit the amount you can borrow to 80% of your home's equity, though some will allow for higher amounts
One way to calculate what you could potentially borrow 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 is 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 until you’ve paid off more of your primary mortgage balance before applying for a home equity loan.
Learn more: How much money you can borrow with 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. Though these vary by lender, to get a home equity loan, you typically must have at least 20% equity in your home. Some lenders will allow you to have 10%, though, so make sure to shop around if you don’t have much equity to pull from.
Your lender will usually order an appraisal of your home to confirm its value and the amount of equity you have in the house.
In addition to having enough equity, 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.
Dig deeper: The requirements to get a home equity loan
Reasons to get a home equity loan
Homeowners can use home equity loans for a variety of purposes, such as:
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Consolidating credit card debt, since credit cards tend to have higher interest rates than home equity products
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Paying for home repairs or improvements
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Buying a car if the home equity loan rate they can qualify for is less than what auto lenders are offering
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Financing a child's education
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Starting a small business
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Paying medical bills
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Investing in ventures that offer higher rates of return than the interest rate a home equity loan charges
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A financial safety net, in case they need cash in a pinch
In short: You can use the funds from a home equity loan however you’d like. And if you use them to “buy, build, or substantially improve” a home, you can even deduct your loan’s interest costs on your annual tax returns.
Keep learning: Is interest paid on a home equity loan tax deductible?
A word of caution
Be careful 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.
Do you pay closing costs on a home equity loan?
Home equity loans typically come with closing costs like your first mortgage. These cover a wide range of expenses, including fees from your lender, third-party service fees (like appraisal fees), and other costs. Typically, you’ll pay between 2% and 5% of the total home equity loan amount.
The wide variety of fees is one reason you should shop around and compare loan offers before choosing where to apply for a home equity loan.
Learn more: What to expect with home equity loan closing costs
Do home equity loans require an appraisal?
You will usually need an appraisal when you get a home equity loan, as this is how the lender will confirm your home’s value, how much equity you have in the property, and how much you can borrow with your loan.
In some cases, lenders may waive the appraisal or allow you to use an Automated Valuation Model instead. This is a tool that uses data and local property records to assign an accurate market value to a home.
If you do need an appraisal for your home equity loan, you can expect to pay about $350 for the service (though this varies depending on factors such as your location and home size). You’ll pay this as part of your closing costs.
Read more: Home appraisal — How it works and how much it costs
Pros and cons of a home equity loan
Pros
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Receiving your money in one lump sum is helpful if you have a large expense
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You can use the money however you see fit, from home improvements to college tuition to paying off debt
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A fixed interest rate means your monthly payments won't change
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Interest paid on a home equity loan could be tax deductible
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Terms are long, often up to 30 years
Cons
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Your home is collateral for the loan, which means you could face foreclosure if you fail to make payments
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You'll pay closing costs
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You must meet qualification requirements, including a minimum credit score, combined loan-to-value (CLTV) ratio, debt-to-income (DTI) ratio, and more
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It adds a second monthly payment to your household
Read more: What is CLTV ratio, and why should homeowners care?
Alternatives to a home equity loan
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, and be sure to compare at least a few different companies.
If you’re not sure a home equity loan is the right move, you can explore several other options for cash instead. These include:
Cash-out refinance
A cash-out refinance is a new mortgage that replaces your current one — only with a higher balance. That loan then pays off your existing mortgage balance, and you get the difference between those two amounts in cash. Like a home equity loan, you can use these funds for any purpose.
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
HECM
A home equity conversion mortgage (HECM) is a special type of government-backed home loan intended for older homeowners (62 and up) who need to access their equity. Repayment isn't required until the homeowner sells the house, moves out, or dies. HECMs are a type of reverse mortgage.
Learn more: What is a HECM reverse mortgage, and do you qualify?
Personal loan
This one doesn’t involve your home equity, but if you need funds and the above aren’t valid options, a personal loan or line of credit may be something to consider. These can be either unsecured or secured by assets (not your home or car), and their term lengths and interest rates vary depending on the lender and your financial situation. Keep in mind that personal loan rates tend to be higher than rates on home equity products.
Read more: Home equity loan vs. personal loan — Which is best for home improvement?
Home equity loan FAQs
What is the downside to a home equity loan?
The main downside to a home equity loan is that it uses your home as collateral, so you can lose your house if you don’t make payments. The same is true for other home equity products, like HELOCs and reverse mortgages.
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. You’ll typically need a credit score in the high 600s and at least 20% equity in your home, though some lenders may offer exceptions.
What is the monthly payment on a $50,000 home equity loan?
The monthly payment on a $50,000 home equity loan would depend on your interest rate and term length. For example, the monthly payment on a $50,000 home equity loan with an 8% rate and 10-year term would be roughly $600.
Do you have to pay back a home equity loan?
Yes, you have to pay back a home equity loan. Depending on the term length, you'll repay the loan in fixed monthly installments for five to 30 years.
How do I qualify for a home equity loan?
To qualify for a home equity loan, you'll likely need 20% equity in your house, a DTI ratio of 43% or less, and a credit score of around 680. Each lender has different requirements, though, so it may be possible to qualify with less equity and a lower credit score in some cases.
What are the typical term lengths and interest rates for a home equity loan?
Home equity loan repayment terms typically last between five and 30 years. Your home equity loan interest rate depends on your term length, lender, credit score, and personal finances, but you can probably expect to pay roughly 8% to 10% right now.
What is the catch to a home equity loan?
The catch with a home equity loan is that your home acts as the collateral for your lender. This means if you fail to make your monthly payments, the lender can foreclose on your home to make up for its losses.
This article was edited by Laura Grace Tarpley.
