What Is a Home Equity Loan?
Home equity is the difference between what your home is worth and the amount you still owe on your mortgage. A home equity loan uses this value as collateral to secure the debt.
Home equity loans are flexible in terms of how you can use the money. There may be tax benefits when using the funds specifically for home improvements, but other common uses include:
- High-interest debt consolidation
- Medical bills
- Business start-up funds
- Higher education expenses
- Weddings or other life celebrations
Home Equity Loan vs. HELOC
There are two primary ways to borrow against your home equity: A home equity loan and a home equity line of credit (HELOC). While they are similar in some regards, they are quite different in how you use them.
Below is a breakdown of the differences between a home equity loan vs. a HELOC:
| Home Equity Loan | HELOC | |
|---|---|---|
| What is it? | A fixed amount of money you borrow for a specific amount of time, secured by your home. The money is typically issued in a lump sum. | A revolving line of credit for a set amount of time, called a draw period. |
| What is the interest rate? | Typically a fixed interest rate | Typically a variable interest rate |
| How is the interest calculated? | On the entire loan amount | Only on the money you borrow, not the available balance |
How Does a Home Equity Loan Work?
If you own a home and have built up equity by paying down the balance or through property appreciation, you may be able to apply for a home equity loan. The lender provides you with a lump sum, which you repay over time with fixed monthly payments.
Loan Amounts and Collateral
To determine how much a lender may be willing to loan you, you’ll need to look at how much home equity you have. In general, you can borrow against your equity until your combined mortgage debt equals 80% of the value of your home – though some lenders will allow you to borrow a higher percentage.
| Appraised Home Value | $350,000 |
| Less Outstanding Mortgage Balance | – $150,000 |
| Home Equity | = $200,000 |
| 80% of Home Value | $280,000 |
| Less Outstanding Mortgage Balance | – $150,000 |
| Potential Loan Amount | = $130,000 |
In this scenario, the $200,000 in home equity is the total equity in your home, not the amount you’re able to borrow. Instead, you can typically borrow until your mortgage and home equity loan amounts represent 80% of your home’s value. So, if you had $200,000 in home equity on a $350,000 home, a lender might approve you for a home equity loan of around $130,000.
The exact amount you can borrow depends on what your lender is willing to offer. The amount offered can vary based on your credit score, income and other financial factors. Like a traditional mortgage, a home equity loan must be paid back before or after selling your home.
Because your home is collateral, there is some risk involved when choosing a home equity loan. If you fail to make payments, the lender can seize the property through the foreclosure process to recoup their funds.
Interest Rates and Repayment Terms
Interest rates for home equity loans are typically fixed-rate and often much lower than rates on unsecured debts like personal loans or credit cards. Because the bank uses your property as collateral to ensure you will repay the loan, the lender can offer a lower interest rate.
Home equity loans can be written with a variety of repayment terms, anywhere from five to 30 years. The longer your repayment period, the more interest you’ll pay over the life of the loan.
Let’s look at an example to understand the impact of repayment:
| Home Equity Loan Amount | $50,000 | $50,000 |
| Repayment Term | 10 years (120 months) | 20 years (240 months) |
| Interest Rate | 8% fixed | 8% fixed |
| Monthly Payment | ≈ $607 | ≈ $418 |
| Total Interest Paid | ≈ $22,797 | ≈ $50,373 |
Comparing the two scenarios, it’s clear that even though the monthly installments are lower in the first example, you end up paying significantly more in total interest over the life of the 20-year loan vs. the 10-year loan term.
Read Carefully
Don’t forget to read all the terms before signing your documents. Lenders may charge a prepayment penalty if you want to pay off the loan sooner. Work with your lender to choose terms that suit your current budget and financial goals.
Application and Approval Process
Applying for a home equity loan is similar to applying for a mortgage. Your lender will review your financial documents and property details to determine your loan eligibility. Below is a general overview of the application and approval process for a home equity loan:
- Evaluate your finances: Before you begin your loan application, take a look at your finances, budget and credit score. People with higher credit scores may receive more favorable loan terms and interest rates. Consider paying down any credit card debt before applying to improve your debt-to-income ratio.
- Collect important documents: You will need several pieces of information to determine your loan eligibility. You may need proof of income, tax returns, bank statements, current mortgage documents and a government-issued ID to get started. Having these important documents in one place can streamline your application process.
- Find a lender: Shop different lenders to compare interest rates, repayment terms and fees before making a decision. You may be able to negotiate with your preferred lender if their competitors have more favorable terms.
- Submit your application: Once you’ve chosen a lender, complete their home equity loan application. Providing accurate and complete information and all requested documentation will help expedite your application process.
- Loan processing: Your lender will take all the information and involve their underwriting department to evaluate the loan. They may verify your employment, pull your credit report and order a home appraisal to help them determine your eligibility and creditworthiness.
- Approval: Once your application is reviewed and approved, the lender will issue a document specifying the loan terms, interest rate and the total amount you can borrow. Even if you have the home equity available, approval is not guaranteed. Approval times can vary from days to weeks.
- and receive funds: The length of the closing process varies by lender, but it can take 45 to 60 days on average, according to our research. There is also a three-day cancellation rule, which allows you to cancel the signed loan within three business days without penalty. Due to this rule, the lender will not disburse your funds until after this period.
Pros and Cons of Using a Home Equity Loan
Home equity loans can be a valuable tool for accessing stored equity. Still, as with any financial decision, they come with benefits and risks borrowers should consider.
Pros of Home Equity Loans
- Low fixed interest rate: Typically, home equity loans come with a low, fixed interest rate, which means payments are predictable and will not change unless you refinance. This predictability makes it easy to budget for repayment, especially for longer-term loans.
- Lump sum: You will receive funds in one payment, meaning you will have instant access to the entire loan amount. This may be ideal if you are using this to pay off debt or start a renovation.
- Tax benefits: If you use the home equity loan for home improvements, the interest on your loan may be tax-deductible. Speak with your tax professional about your individual situation.
Cons of Home Equity Loans
- Cost: Like a traditional mortgage, home equity loans have closing costs and other fees to initiate the loan. These fees can often range between 2% and 5% of the total loan balance.
- Foreclosure risk: One of the biggest drawbacks of a home equity loan is that your house serves as collateral. If you fail to make the payments, you risk losing your home to foreclosure.
- More debt: A new loan increases your monthly payment obligations. This additional debt could add stress and strain if your financial situation changes. Make a budget and ensure you can easily make the payments before taking out a loan against the value of your home.
How To Pay Off a Home Equity Loan
By making consistent monthly payments until the loan is fully repaid, you can pay off the home equity loan effortlessly. Prioritize these payments to maintain a good credit history and protect your home.
Structured Repayment
Typically for a home equity loan, the repayment plan involves a monthly payment schedule with both principal and interest in one payment. Borrowers know what their payment will be every month throughout the life of the loan. This predictability simplifies repayment and can give peace of mind.
Early Repayment Strategies
If you want to pay your home equity loan off early, start by reviewing your loan agreement. Some loans may have prepayment penalties or restrictions for paying off the loan before a certain time frame. If there are no penalties, here are some strategies to pay off your home equity loan early:
Paying more than the minimum required amount each month reduces the principal balance faster, leading to lower overall interest costs. Be sure to specify that the extra payment amount should go toward the principal.
Instead of making one monthly payment, consider making half of your monthly payment every other week. This results in 26 half-payments each year, which is equivalent to 13 full payments. Over time, this extra payment can add up and reduce your loan balance.
Rounding up your monthly payments can make a difference, even if the amount is small. For example, if your monthly payment is $475, try rounding it up to $500. You likely won’t miss that small amount in your budget, but it can add up to make a dent in the amount owed.
If you receive financial windfalls, such as a work bonus, inheritance or a tax return, consider using some or all of it to make a one-time payment toward the principal of your loan. These extra lump sum payments can significantly accelerate your loan payoff.
If you’re in a good financial position and interest rates are low, consider refinancing your home equity loan into a shorter-term loan. This can result in higher monthly installments but a quicker payoff with less interest.
Tips for Getting a Home Equity Loan
Getting a home equity loan starts with understanding the available equity in your home and your creditworthiness.
Assess Your Financial Situation
Home equity loans usually have a structured repayment plan that combines principal and interest into a single monthly payment for the life of the loan. This predictable payment helps borrowers to adequately plan for their current budget and for the entirety of the repayment period. Because your home is the collateral for the loan, carefully consider your current financial obligations and your ability to make payments.
Choose the Right Lender
Shop around for lenders when getting a home equity loan. Consider not only interest rates and fees but also check repayment policies and customer reviews. By visiting multiple lenders, you may be able to negotiate terms and fees, especially if you are a desirable borrower.
Read the Fine Print
Before committing to a home equity loan, it’s crucial to understand the terms and conditions thoroughly. Take your time to review the agreement and watch out for prepayment penalties, annual fees or terms that could affect your ability to make additional payments or refinance the loan. Consult a financial adviser or lawyer if you need help understanding the loan documents. Making a well-informed decision helps you avoid unexpected financial surprises down the road.
The Bottom Line
Is a home equity loan right for you? That’s going to depend on your individual situation. Start by taking a look at your finances and credit score. Creditworthiness plays a big role in what loan terms and interest rates are available to you.
While there are benefits to a home equity loan, such as predictable payments, tax advantages and lump-sum amounts, this type of loan isn’t without risk. A home equity loan uses your home as collateral, which means you can lose your home to foreclosure if you are unable to pay back the loan. Take your time to assess your finances, thoroughly understand the terms and make sure a home equity loan is the best option for you.
If you think a home equity loan is right for you, check out our list of the best home equity loan lenders of 2024.
Frequently Asked Questions About Home Equity Loans
Home equity loans are a secured debt, which can put your home at risk if you can’t make the payments. Closing costs and fees add to the overall expense of the loan. While real estate historically rises long term, falling home values in the short term could lead to negative equity or “being underwater.”
Taking equity out of your house can be a good idea for home improvements, high-interest debt consolidation, essential expenses or education. However, it’s not advisable for non-essential spending, as it carries the risk of losing your home. Carefully assess your financial goals, income stability and market conditions before tapping into your home’s equity. Consider consulting a financial advisor for more guidance before making a decision.
Yes. Both home equity loans and HELOCs are good options to access your home’s equity without refinancing. Home equity loans provide a lump-sum payment, while HELOCs function like a credit card that you can draw from as needed. Both options have their own terms, interest rates and fees.
If you can’t pay back a home equity loan, your lender can foreclose on your home. If your financial situation changes and you will not be able to make payments, contact your lender about repayment options.
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