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What is a home equity loan and how does it work?
This type of loan turns your home’s value into a lump sum of cash.
Home equity loans can be used for home renovations, buying more property or even paying for your kid’s college tuition. But they’re called “second mortgages” for a reason — you may be on the hook for closing costs, depending on the lender, and have another monthly payment to boot.
Home equity loan defined
A home equity loan is a type of loan that uses your home’s equity as collateral. It’s also known as a second mortgage or equity loan.
To qualify for a home equity loan, the value of your house must be greater than the amount you still owe on it. In other words, you must have built “equity.” Equity is the difference between your mortgage balance and your home’s current market value. For example, if you have a mortgage balance of $100,000 and your home is worth $200,000, then your equity is $100,000.
How home equity loans work
A home equity loan works much like a regular mortgage — you apply for a loan and undergo a credit check. Once approved, you pay closing costs and get a lump sum of cash to use for anything — from home improvements to paying off credit card debt.
Here’s a closer look at how home equity loans work in terms of interest rates and fees:
- Interest rates. Unlike HELOCs, home equity loans have fixed rates that range from 3.5% to 9.25%, depending on your credit score.
- How much you can borrow. You can typically borrow 80% to 90% of your home’s value, minus your remaining mortgage balance. This is also known as your loan-to-value ratio (LTV), and you can use a home equity calculator to figure it out.
- Repayment terms. Home equity loans have terms ranging from five to 15 years. And just like a regular mortgage, you make monthly payments toward principal and interest.
- Fees. Similar to your primary mortgage, some lenders charge closing costs on home equity loans — but not all do. Learn more about closing costs on home equity loans and home equity lines of credit (HELOCs).
A closer look at a home equity loan
Suppose your home is worth $300,000 and you have $175,000 left on your mortgage. This means you’ve built $125,000 in equity.
If you find a lender that lets you borrow against 80% of your equity, you could take out a loan for up to $100,000.
Now let’s say you lock in a $100,000 home equity loan with a 20-year repayment term and a fixed 5.80% APR. Your monthly payment would be around $705. And you would most likely pay $2,000 to $5,000 in closing costs, plus any miscellaneous lender fees.
Home equity loan requirements
You may qualify for a home equity loan if you have:
- At least 15% equity built up in your home.
- A debt-to-income ratio of up to 50%.
- A credit score of 620 or higher.
- The ability to repay your loan based on income, assets, monthly costs and credit history.
Benefits of home equity loans
Taking out a home equity loan has several benefits — especially compared to HELOCs or personal loans:
- Competitive interest rates. Home equity loans have lower interest rates than predatory personal loans, which can be as high as 650% in states with no protections. They also have fixed interest rates, which can make them a preferred option over HELOCs that fluctuate based on market conditions.
- No restrictions. You can use the money you get from your home equity loan for literally anything — making changes to your home, sending your kids to college, paying for a large medical expense or even buying more property.
- Could be tax-deductible. You may be able to deduct the interest you pay on a home equity loan if you use the funds for qualifying home improvements. However, this deduction applies only to the first $750,000 you have in mortgage debt.
Drawbacks to home equity loans
While home equity loans can be a good choice for some borrowers, look out for potential drawbacks that include:
- Risk of losing your home. A major downside to a home equity loan is that you could lose your home to foreclosure if you default on it. This can be a big concern if you’re already struggling to make one mortgage payment, let alone two.
- Limited borrowing amount. The maximum amount you can borrow is 80% to 90% of your home’s value, minus your outstanding mortgage balance. This limit could be too low depending on the size of your expense and your equity limit.
- Not available to everyone. Home equity loans require you to have at least 15% equity built up in your home. If you’re still early on in your mortgage, you may not qualify for a loan.
How the government protects borrowers
The government puts several regulations in place to help protect borrowers from predatory lending practices. The biggest is the Home Equity Home Ownership and Equity Protection Act (HOEPA).
HOEPA places restrictions on lenders, such as limiting specific fees, requiring proper disclosure of loan terms and conditions and mandating that loans meet specific underwriting standards.
Other regulations include the three-day cancellation rule, which gives borrowers the right to cancel a home equity loan within three days of signing the contract. This allows time to back out of a loan if you realize you can’t afford it or aren’t comfortable with the terms.
Home equity loans vs. HELOC
Home equity loans work just like traditional mortgages: You pay closing costs when you get the loan, repaying the loan over time in the form of fixed-rate monthly payments.
HELOCs, on the other hand, work like credit cards: You’re approved for a specific amount of credit that you then pull from as needed. You pay interest on the portion you use only, and your interest rate can fluctuate as markets change.
In most cases, a home equity loan is best if you need money for a one-time expense and want fixed monthly payments. A HELOC is best if you have ongoing expenses or need quick credit approval.
To learn more about similarities and differences, read our home equity loans vs. HELOC guide.
Compare interest rates for home equity loans, HELOCs and cash-out refinancing
Use our tool to get personalized estimated rates from top lenders based on your location and financial details. Select whether you’re looking for a Home Equity Loan, HELOC or Cash-Out Refinance.
If you selected a home equity loan or HELOC, enter your ZIP code, credit score and information about your current home to see your personalized rates.
In the Cash-Out Refinance tab, select Refinance and enter your ZIP code, credit score and other property details to see what you might qualify for.
More alternatives to home equity loans
A home equity loan is just one of many options available to access the equity in your home. Two other alternatives include:
- Cash-out refinance. A cash-out refinance lets you tap into your home equity by replacing your existing mortgage with a bigger one. Closing costs and borrowing amounts are similar to a home equity loan — but you get one mortgage payment instead of two.
- Home sale-leaseback. If you have plans to move, this option could be a good fit. It’s where you sell your home to a buyer so that you get access to the equity in it. Then, you rent the place out from them until you’re ready to move.
Any loan you take out on your home should be considered carefully, as it can affect your finances for years to come. That said, browse home equity loans and compare offers from multiple lenders to find the best rates and terms for your budget and financial goals.
More guides on Finder
Is home equity loan interest tax deductible?
Home equity loan interest is tax deductible, but only in certain circumstances.
Home equity loan payment calculator
Use this calculator to estimate your monthly payment for a home equity loan.
How to get a home equity loan with bad credit
A steady income, more equity and low debt are key to getting approved with bad credit.
Hometap equity partners review
Access your equity through a partnership that shares in your home’s appreciation — or not — over 10 years.
How to get preapproved for a home equity loan
Here are questions you should prepare for when getting preapproved for a home equity loan.
How long does it take to get a home equity loan?
It varies, but be prepared to gather documentation and verify your financial situation.
Discover Home Equity review
Offers a $0 closing home equity home in 48 states, but no HELOCs.
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