What is a home equity loan?

If you need to cover a major, ideally wealth-building expense, such as home renovations or college tuition, a home equity loan might seem like the perfect solution. This fixed-rate, lump-sum “second mortgage” is often cheaper than credit cards and personal loans, and it won’t force you to give up the low APR on your home loan.

However, this financial product isn’t foolproof. Like mortgages and cash-out refinancing, home equity loans have closing costs, among other fees. Plus, if your repayment goes awry, your home could be foreclosed, or seized by the lender.

As with all forms of borrowing, home equity loans are best avoided by budgeting and saving over time, but if you decide they’re truly a good fit for your situation, here’s what to know.

What is home equity?

Home equity refers to the portion of your home that you own outright, versus the portion you still owe to the mortgage lender. To find out how much equity you have, take the current market value of your home and subtract any liabilities, such as the mortgage. The difference is your equity.

For example, say you own a home worth $300,000, but you still owe $150,000 on the mortgage. That means you have $150,000 in equity, or 50%. You’re long past the 20% threshold needed to avoid mortgage insurance. And, once you pay off the mortgage completely, you’ll have 100% equity.

Building home equity takes time, and it can be done in several ways. For example, making regular mortgage payments and gradually reducing the principal owed increases your equity.

Increasing your home’s market value can also result in more equity, whether you make certain improvements or additions, or let it happen naturally (home values increase by an average of 3% per year). That said, home values don’t always trend upward in the short-term.

“Depending on the market, your home equity can go up or down,” said Laine Blackmon, a mortgage loan officer at Blackmon Home Loans in Nevada.

How home equity loans work

A home equity loan, which is often referred to as a “second mortgage” or “lien”, allows you to borrow against the equity you’ve accrued. The funds arrive in a lump-sum disbursement that’s paid off in monthly installments over anywhere from five to 30 years, similar to a traditional home loan.

Your property also serves as the collateral for the loan. That means if you can’t afford to repay your loan, you could risk losing your home to foreclosure.

To determine how much you can borrow, calculate your loan-to-value ratio (LTV). This is a measure of how much you owe on your home relative to its current market value. It’s another way to look at how much equity you have. The best home equity lenders typically allow you to borrow 80% to 85% of the equity in your home (though some may go higher if you have excellent credit).

Say you get approved to finance 80% of your equity. To calculate your LTV, subtract the existing balance of your primary mortgage from 80% of the appraised value of your home.

Following our previous example, you’d multiply your home’s value of $300,000 by 0.80, which equals $240,000 (an LTV of 80%). Then you’d subtract your mortgage balance of $150,000. The result is $90,000, which is the maximum amount you could finance with a home equity loan in this scenario.

Types of home equity loans

There are other financial products that allow you to leverage your home equity. These products have a few things in common, such as the risk of foreclosure if you default during repayment.

Advantages of home equity loans

Home equity loans allow you to leverage the progress you’ve made on your mortgage without refinancing to a higher interest rate or selling your home. Here are other advantages to consider.

Relatively low interest rates

When it comes to borrowing money, home equity loans feature lower rates than other financial products, and are comparable to mortgage rates. In November 2023, advertised rates started under 9% for borrowers with good credit.

By comparison, 24-month personal loans (12.17%) and credit cards (21.19%) carried higher average interest rates, according to the latest data from the Federal Reserve Board.

Predictable payments

Lines of credit and some loans carry variable interest rates that fluctuate according to market conditions. If interest rates go up, so do your payments.

But many home equity loans come with fixed interest rates, meaning they stay the same throughout repayment. This gives you predictable monthly dues, which can help you budget more effectively.

More relaxed qualifications

Taking out a home equity loan requires you to meet certain eligibility standards, such as good credit and a low debt-to-income ratio. That said, it may be easier to qualify for a home equity loan versus other types of unsecured loans or lines of credit because your home serves as the collateral — and you’ll be highly motivated to keep your property.

Potential tax benefits

You may be able to deduct a portion of your home equity loan interest — but only if the loan funds certain home improvements, such as an addition to the existing structure. If you’re borrowing money to cover home renovations, this could be an added perk of using a home equity loan. As always, it’s wise to consult a certified tax professional before moving forward.

Disadvantages of home equity loans

After months or years of making a dent in your mortgage balance, you might be understandably reticent to see your equity percentage drop. Here are other potential drawbacks and risks of home equity loans.

Risk to your home

Although your home equity can serve as a convenient source of financing, the trade-off is that your home backs the loan (as its collateral). If you run into financial hardship and can’t keep pace with payments, you run the risk of losing your home to foreclosure.

Additional fees

Home equity loans aren’t free to borrow. For instance, you likely need to get your home appraised to find the current market value, which can cost anywhere from $600 to $2,000.

And like a traditional mortgage, there are usually closing costs associated with a home equity loan, which are typically 2% to 6% of the loan amount.

Two mortgages

Taking on a home equity loan in addition to your primary home loan means you’ll essentially have two mortgages to manage. This results in a larger amount of debt, reduced disposable income and increased risk of overstretching your budget.

Mortgage could go underwater

When you owe more on your mortgage than your home is worth, you have what’s known as negative equity, or more casually, an underwater mortgage. This can happen if you leverage most of your equity and then your home value drops.

If you plan to stay in your home for several more years, this may not pose as much of a risk, since you’ll gain more equity over time. However, if you were hoping to refinance or sell soon, it could be an issue.

Balance could come due if you sell

If you decide to move and list your property for sale, be aware that your home equity loan balance would come due in full, similar to a 401(k) loan being due if you switch employers. As a result, you’ll have to account for paying off a home equity loan upon closing the sale of your property.

Qualifying for a home equity loan

The eligibility requirements for a home equity loan vary by lender, but here are common guidelines that you’re likely to encounter:

• Credit score: You’ll need good credit to qualify for a home equity loan. Some lenders may accept scores in the mid-600s, but a score of 700 or above is generally preferred for the most favorable interest rates and terms.
• Loan-to-value ratio (LTV): Lenders usually allow you to borrow up to 80% to 85% of your home’s value, for an LTV of 15% to 20%.
• Debt-to-income ratio (DTI): This measures how much of your monthly gross income goes toward debt repayment each month. A DTI of less than 50% is typically preferred, although some lenders might allow a higher DTI, particularly if you have great credit and/or plenty of cash reserves.

Applying for a home equity loan

The exact process of applying for a home equity loan depends on your prospective lender. Generally, however, you’ll need to complete the following steps:

1. Review your finances. Check your credit reports and score to ensure there are no issues, and review your budget to determine how much you can afford to pay each month.
2. Research loan options. Every lender is different, so it’s wise to get several quotes and determine which one fits your needs best. This can often be done online via a soft credit check, so your credit score won’t be impacted. Once you settle on a lender, double-check that they’re reputable and customers are generally happy with their service. You can review free online resources like the Better Business Bureau and the Consumer Financial Protection Bureau’s complaint database.
3. Gather necessary documents. Getting your documentation together ahead of time will help streamline the application process. You’ll need to provide proof of income, recent tax returns and W-2s, details about your mortgage, bank statements showing your assets and debts and more.
4. Complete the application. Once everything is in order, fill out your application (most major lenders allow you to do this online). It’s important that all the information you provide is complete and accurate, otherwise the underwriting process could be delayed and it’ll take longer to get approved.
5. Schedule a home appraisal. No, your lender is unlikely to trust the estimate on Zillow, Trulia and other property search engines. You’ll likely need to have an official appraisal done so you know the current market value of your home and your maximum borrowing potential.

Tips for using home equity loans wisely

If you plan on taking out a home equity loan, ensure you can pay it off on schedule.

• Crunch the numbers. Before you get too far into the application process, be sure you know how a home equity loan will fit into your budget and how much you can afford to borrow.
• Shop around for the best rates. Getting the lowest possible interest rate will cut the long-term cost of your loan by thousands. Remember, having good credit will increase your chances of qualifying for the lowest rates available.
• Understand all the costs. It’s also helpful to choose a loan that doesn’t come with a lot of fees, especially if you roll them into the balance. Ask for a detailed breakdown of closing costs, as well as any prepayment penalties.
• Don’t overborrow. Just because you’re approved for a certain amount doesn’t mean you need to take it. Limit your borrowing to just what you need; the more you borrow, the higher your payments will be and the more you’ll pay in interest over the life of your loan.