How does a home equity loan work?

A home equity loan (aka second mortgage) lets you borrow using the equity in your home as collateral. To estimate your home equity, take your home’s current value and subtract what you owe on your mortgage. So, if your home is worth $300,000 and your mortgage balance is $100,000, your equity would be $200,000.

Once you’re approved for a home equity loan, your lender gives you the funds as an upfront lump sum. This makes home equity loans ideal for homeowners who want to borrow a specific amount for a major project or big one-time expense. To repay the loan, you make fixed monthly payments (with interest, of course) over a set term ranging from five to 30 years.

TIP: Remember that home equity loan payments are in addition to your usual mortgage payments, so budget accordingly. If you default on the loan payments, your lender can foreclose on your home.

Many lenders let you borrow up to 80% of your available home equity. If you have $200,000 in equity, for example, you can borrow up to $160,000. Of course, the loan amount also depends on your financial situation: Lenders consider factors like your credit score, income, employment history, and debt-to-income (DTI) ratio when deciding whether to approve or deny your loan application.

You can use a home equity loan for virtually anything, but some choices are better (i.e., more financially sound) than others. It’s wise to focus on things that boost your home’s value or improve your financial situation in some other way — say, home improvements or debt consolidation. Conversely, spending on unnecessary expenses like an extravagant vacation or a risky investment is ill-advised. Remember: Your home secures the loan, and your lender can foreclose if you default.

Home equity loan rates and HELOC rates are generally have higher than mortgage rates because they represent a larger risk to the lender. Several factors influence interest rates, including inflation, job growth, the Federal Reserve’s monetary policy decisions, and your financial situation.

According to Bankrate, the average home equity loan rates as of June 2023 are:

• 10-year fixed: 8.40%

• 15-year fixed: 8.35%

The average home equity line of credit (HELOC) rate is 8.51%. Shopping around with at least three lenders can help you find the best home equity loan rates and the best HELOC rates.

TIP: The rate you lock in for a home equity loan or HELOC could be higher or lower than the average rate, depending on your credit score and other factors.

Home equity loans and HELOCs let you tap into your home equity, but they work differently. A home equity loan is a lump-sum payment, so it can be a good option if you need a set amount of money for a particular project. On the other hand, a HELOC is a revolving credit line that you can draw from as needed for a certain number of years. This makes a HELOC a smart choice if you don’t have an exact budget or timeline in mind.

You’ll need to meet specific requirements to get a home equity loan or HELOC, much like when you got your mortgage. The requirements are generally the same whether you get a home equity loan or HELOC, but they vary by lender. Still, here’s what lenders typically look for:

1. At least 15% equity in your home

Your home serves as collateral, so your lender will expect you to have a minimum amount of equity. The more equity you have, the more you can usually borrow. Lenders also use a related metric called the loan-to-value ratio (LTV) to measure a loan’s potential risk and decide whether to approve your application. To calculate LTV, divide your current loan balance by your home’s value. Lenders consider loans with higher LTVs riskier because your stake in the house is lower.

As equity increases, LTV decreases. To illustrate, here’s what happens to equity and LTV as the loan balance drops on a $500,000 home:

Another calculation is the combined LTV (CLTV) ratio, which compares the value of your home to the combined total of loans it secures. To calculate CLTV, divide your combined loan balance by your home’s current appraised value. Most lenders require a CLTV below 85% to approve a home equity loan or HELOC.

2. A credit score above 620

You’ll likely qualify for a loan with a credit score of 680 or higher if you meet the other requirements, but some lenders prefer a score of 700 or more. If your credit score falls below 680, you might still qualify if your financial profile is strong in other areas. Lenders also like to see a strong history of paying your bills on time because it shows you’re a reliable borrower.

3. A DTI ratio below 50%

Your debt-to-income (DTI) ratio is your total monthly debt payments divided by your gross monthly income. The lower your DTI, the better (it indicates your debt is manageable). Qualifying DTI levels vary by lender: Some require your DTI to be 36% or less, while others accept DTIs as high as 43% or 50%. Also, lenders require income proof to confirm you can manage your loan payments.

Homeowners in the U.S. are holding near-record levels of equity. While some real estate markets are seeing price drops, housing experts don’t expect a repeat of the Great Recession. As such, now might be a good time to consider a home equity loan or HELOC as housing prices remain high. 

HELOC and Home Equity Loan FAQs

What are good home equity loan rates?

The best home equity loan rates can vary by lender. The average national rate for a home equity loan in June 2023 was between 7.52% and 9.81%. To find the most competitive rates, it’s best to do your research and shop around for the right lender for your needs.

What are the best HELOC rates?

As of June 2023, the average national rate for a home equity line of credit (HELOC) is between 7.79% and 9.78%. To get the best HELOC rates you will need to have a good credit score, a low debt-to-income ratio, a high enough income, and a reliable payment history. Even if all of these factors apply to you, it’s important to get quotes from at least a few lenders.

How does a HELOC work?

A HELOC is a revolving line of credit, which makes it similar to using a credit card. HELOCs usually come with a draw period of 10 years, followed by a repayment period. During the draw period, you can access funds as needed and repay only the interest as you go. Each time you make a payment, your credit line will replenish. During the repayment period, you’ll make larger payments that include both principal and interest. HELOCs tend to come with variable interest rates, but some lenders offer fixed payment options. A HELOC is a great option if you’re not sure how much you’ll need to borrow.

What is a fixed-rate HELOC?

A fixed-rate HELOC is considered a hybrid product because it combines a home equity loan’s fixed interest rate with a HELOC’s credit line. You can withdraw money (up to your credit limit) just like you would with a traditional HELOC. But unlike a variable HELOC, you lock in all or a portion of your balance at a fixed interest rate during the draw period. This can make it easier to plan and budget while protecting you from future interest rate hikes. 

What is the best HELOC strategy?

Just because you can use a HELOC for anything doesn’t mean you should. After all, your house is on the line, and you risk losing it to foreclosure if you default on the payments. For this reason, the best HELOC strategy is to use the HELOC to boost your home’s value or strengthen your financial situation in some other way. 

Is HELOC interest tax deductible?

The interest you pay on a HELOC can be tax-deductible — but not always. It all depends on what you use the funds for. According to the IRS, you can only deduct the interest you pay on a home equity loan or line of credit if “the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan.” Here’s a closer look at the nuances involved in the question of whether heloc interest is tax-deductible.

How can I increase my home’s value?

If you’re researching home equity loans and HELOCs, you’ve probably started wondering how you can increase your home’s value. Check out our guide for tips, including investing in smart energy, replacing your roof, and refinishing hardwood floors.

What is a home improvement loan?

A home improvement loan is an unsecured loan that you can use to pay for various home repairs and renovations — such as a roof replacement, furnace/HVAC repairs, kitchen or bathroom remodel, deck addition, solar panel installation or landscaping. Loan amounts range from $3,000 to $100,000, which you repay with interest in monthly installments over one to five years.

How can I get a home equity loan?

While the process varies by lender, this is generally how to get a home equity loan:

1. Calculate how much equity you have in your home.

2. Decide how much you need to borrow.

3. Compare borrowing limits, features, terms, and customer reviews across lenders.

4. Get quotes from a handful of lenders that meet your needs.

5. Choose the lender with the lowest rate offer and submit a formal application, which will require a hard credit check.

6. Schedule an appraisal.

7. Wait for approval and close on your loan.

8. Begin repayment.

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was originally published on SFGate.com and reviewed by Lauren Williamson, who serves as Financial and Home Services Editor for the Hearst E-Commerce team. Email her at [email protected].