What Is a Home Equity Loan?

Vault’s Viewpoint on Home Equity Loans

• Home equity loans let homeowners borrow against the equity they’ve built up in their house (essentially, the portion of the house they own outright).
• The proceeds from a home equity loan can be used however you want.
• Homeowners should weigh the pros and cons carefully before taking on this type of second mortgage.

Understanding Home Equity

If you like the idea of converting some of your home’s value into cash, you’re probably wondering, “How does a home equity loan work?” To clear that up, it’s first helpful to look at home equity on its own.

Your equity in your home is how much of the home value you actually own. You can calculate this relatively easily:

• Home equity = Current home value – Your mortgage balance

Let’s say your house is currently valued at $450,000 and you still owe $275,000 to your mortgage lender. In that case, you have $175,000 ($450,000 –$275,000) in equity.

Once you calculate your equity, keep that number in mind. It directly impacts how much you can borrow with a home equity loan.

How Home Equity Loans Work

Home equity loans function a lot like a mortgage—in fact, they’re a type of second mortgage. So, how does a home equity loan work, exactly?

You apply for the loan with any lender. It doesn’t have to be the company that originated your mortgage. Whether or not you get approved—and the interest rate you pay if you do—depends on your borrower profile and how much you’re trying to borrow (more on that below).

If you get approved, the lender issues you a lump sum of cash. You pay that back plus interest over the loan’s term, which is usually five to 30 years.

Home equity loans typically have fixed interest rates, which means your monthly repayment to your lender stays the same the entire time you’re making repayments.

You can use the money you get from a home equity loan however you want. What is a home equity loan going to do for you? Think carefully about the answer and ensure this kind of financing can yield long-term benefits. There’s an inherent risk with the type of loan.

That’s because as you’re repaying the loan, your home serves as collateral. If you fail to repay what you’ve borrowed, the lender can seize your house. And if real estate values fall significantly, the home equity loan paired with your mortgage could mean you owe more than your home is actually worth.

How To Get a Home Equity Loan: Qualification Criteria

Even with the risks of home equity loans, they’re appealing to many homeowners. If you’re considering one for yourself, you first need to find out if you’re eligible for this kind of loan. To figure out how to get a home equity loan, there are a few categories you need to look closely at:

Your Equity

Many lenders want to see that you have at least 20% equity in your house, although some allow for as little as 10%.

So with our example of a $450,000 home, you would most likely need equity of $90,000—meaning your mortgage balance needs to be $360,000 or less.

Your Combined Loan-To-Value (CLTV) Ratio

Lenders want to make sure you don’t take on more debt than you can handle. As a result, a lot of lenders only issue home equity loans if the borrower’s CLTV ratio is 80% or below.

The “combined” aspect of the ratio means you need to factor in both your current mortgage and the amount you want to borrow through the home equity loan.

You can find out how much you’re eligible to borrow with the following equation:

• Home value * allowable CLTV ratio = mortgage balance –maximum you can borrow

Let’s say you have a $450,000 home value, a $275,000 mortgage balance and the lender allows for a CLTV up to 80%, for example.

• $450,000 * .8 (80%) is $360,000

Your mortgage balance eats up $275,000 of that, leaving you with the potential to borrow up to $85,000 with a home equity loan.

Your Debt-to-Income (DTI) Ratio

While your house serves as collateral for the home equity loan, lenders don’t necessarily want to have to seize it and sell it to recoup their losses. As a way to make sure you’re probably going to be able to handle repayment, they also evaluate your debt-to-income (DTI) ratio.

To calculate this, add up all your monthly debts, including:

• Your mortgage
• Your potential home equity loan repayment
• Any credit card debt
• Other outstanding loans, like car and student loans

Then, divide that by your gross monthly income. Most lenders want to see a DTI of 43% or lower, although some will go as high as 50%.

Lowering your DTI could be key as you figure out how to get a home equity loan. Not only will it increase your chances of approval, but a lower DTI can help you score a lower interest rate.

Your Credit Score

Lenders look at your credit score to see how you’ve handled your money in the past. Most home equity lenders want to see a score of 620 or above.

Just like other factors on the list, the more you can improve your borrower profile in this area, the more it can help to lower your home equity loan interest rate.

Ways To Use Home Equity Loans

Before taking out a second mortgage and putting your house on the line, ask yourself: What is a home equity loan going to do for me? Generally, experts only recommend it when it will support long-term financial goals.

For example, you might use it to:

• Pay off other higher-interest debt. If you have a major credit card balance or another type of debt that comes with a high interest rate, using a home equity loan to pay it off might make sense. The fixed payments of this type of financing can help you stick with a debt repayment plan, too.
• Finance a home improvement. If you want to tackle a major renovation, a home equity loan can cover the cost. And because that improvement should boost your property value, you might even recoup some of the equity you cash out. Plus, through tax year 2025, using the money to build onto or otherwise significantly improve your home is the only way to claim a tax deduction on the interest.
• Fund education. Whether you want to pursue an additional degree or you’re looking for alternatives to student loans for your kids, home equity loans are an option.
• Starting a business. If you need cash on hand to get a new company off the ground, your home can secure the loan, helping you get that capital while paying less interest than with, say, a personal loan. Be advised, though, that you’re risking your home. Be sure you can stick with the repayment plan even if your business struggles.
• Cover emergency expenses. Whether you just had a medical emergency or you totaled your car, you might find yourself suddenly needing a lump sum of cash. Home equity loans deliver exactly that—and they do so at a lower interest rate than credit cards, which many Americans use to cover emergency expenses.

Ultimately, the money you get from a home equity loan can be a useful tool that improves your life and your financial outlook. But this debt can also be burdensome, and it puts your house on the line. Before you take it on, consider the pros and cons carefully.

Other Ways To Use Home Equity

Home equity loans are just one way to tap your home equity for cash. You can also explore:

Home Equity Lines of Credit (HELOCs)

HELOCs, another type of second mortgage, similarly let you borrow against your home equity. But how does a home equity loan work differently than a HELOC? It’s all about the type of financing.

While home equity loans let you borrow a lump sum at a fixed interest rate, HELOCs give you a line of credit from which you can borrow up to the maximum amount. And that’s not the only way they function more like a credit card. HELOCs have variable interest rates, too.

Cash-Out Refinances

This option replaces your current mortgage with a new one. Most cash-out refinances mean taking out a bigger mortgage, and then pocketing the difference.

If you still owe $275,000 on your mortgage and your house is valued at $450,000, for example, you might refinance into a $375,000 mortgage. You would then use the new home loan to pay off your previous mortgage balance of $275,000, leaving you with $100,000 in cash.