What Is a Home Equity Loan? Defined & Explained

One of the biggest benefits of homeownership is the accumulation of equity. With every mortgage payment, you own a larger and larger percentage of your home. When your mortgage is paid off, you have 100% equity, which is a fancy way of saying that you own the house outright.

But how do you take advantage of that equity? You could sell your house and collect the full cash value, but then you’d have to spend a lot of that money on a new house. Besides which, you might not want to move out of your house. In that case, is all your equity useless?

Not quite. With a home equity loan, you can access the equity in your home, without moving out. Because these loans are backed by the value of your home, they tend to come with lower interest rates than a regular personal loan. In that sense, they’re similar to a mortgage, which is one of the cheapest forms of debt available.

So, what is a home equity loan, and how can you use one to your advantage? Here, we’ll walk you through the entire process. By the time you’re done reading, you’ll be a home equity loan expert.

What Is a Home Equity Loan?

A home equity loan is a specific type of consumer loan. Also called equity loans, second mortgages, or home equity installment loans, these loans allow you to use the equity in your home as collateral. The amount of credit available will depend on your current equity in the home.

The amount of equity is calculated by subtracting the mortgage’s outstanding balance from the home’s current market value. The more equity you have, the more you’ll be able to borrow. Conversely, if you still owe a lot of money on the house, you’ll have a lower borrowing limit.

Home equity loans are not to be confused with home equity lines of credit (HELOCs). We’ll look closer at the differences in a second, but there are two main ones. First, home equity loans almost always have a fixed interest rate. HELOCs, by comparison, typically have a variable rate. Second, home equity loans pay out in a single, lump sum payment. HELOCs are revolving lines of credit, more similar to a credit card.


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home equity loan

How Does a Home Equity Loan Work?

A home equity loan is similar in many ways to a mortgage, which is why they’re often called second mortgages. Much like a mortgage, you can’t borrow against 100% of the home’s equity – the lender still wants you to have some skin in the game. In most cases, the approved loan-to-value ratio will be between 80% and 90% of the home’s appraised market value. The exact amount, as well as the interest rate, will also depend on other factors, such as your credit score.

Just like your first mortgage, a second mortgage will have a pre-defined monthly payment and payment term. You make the same payment every month, which includes a combination of interest and principal. When the loan is paid off, you’ll once again have full equity in the home. That said, remember that your house is being used as collateral. If you fail to pay off the loan, the lender could foreclose on your home and sell it to recoup the money.

Equity is great for long-term financial security, but sometimes, you need cash right now. The main benefit of a home equity loan is that it allows you to access the equity in your house. In fact, some people use home equity loans to pay for home improvements. The logic is that you’re actually adding value to the house, so it will be worth more when the loan is paid off.

Keep in mind, though, that real estate prices don’t always go up. If the market takes a turn for the worse, you could end up underwater on your mortgage – owing more than the house is actually worth. This isn’t always a disaster. If you’re staying in the same house for the long term, the market should eventually recover. But if you’re planning to relocate, you might end up having to sell the house for a loss. And if you don’t have cash to cover the loan balance, you won’t be able to sell at all.

Before you take a home equity loan, make sure to look at interest rates on other loan types. Depending on how much you’re borrowing, a HELOC or cash-out refinance could be a better deal.

Home Equity Loan Requirements

Different lenders will have their own individual approval requirements. That said, you’ll normally need to meet these basic standards:

  • Own at least 20% equity in your home

  • A credit score of 600 or better

  • Two years of verifiable income records

To find out how much equity you have, you’ll need to know how much your home is worth. Look up similar properties on a site like Zillow, and see what they’re selling for. Keep in mind that this won’t be 100% accurate, and your lender may want to have the home appraised by a professional appraiser.

When you have a rough estimate of your home’s value, you next need to know how much money you still owe. If you’ve paid off your mortgage and haven’t taken out any new loans, that amount will be zero. But if you have a mortgage, HELOC, or existing second mortgage, you’ll need to check your statements and add up how much you owe. Subtract that from your home’s value, and you know your total equity.

Keep in mind that while almost all lenders will have minimum equity requirements, some may be more flexible about credit scores and income. That said, if you don’t meet these standards, you’ll have to go through a lender that services high-risk borrowers. You can also expect to pay a higher interest rate.

Normally, applications are accepted or rejected based on merit. In fact, it’s illegal for lenders to discriminate based on race, religion, gender, and other protected categories. If you think you’ve been discriminated against, you can file a complaint with the Consumer Financial Protection Bureau.

Depending on various factors, you’ll pay different rates of interest. Here’s a quick overview of what you can expect to pay:

Type of LoanAverage Interest RateRange
5-year Fixed5.28%2.5%-9.99%
10-year Fixed5.6%2.99%-9.99%
15-year Fixed5.82%2.99%-9.03%
HELOC5.61%3.5%-8.63%

Home Equity Loan vs. HELOCs

A home equity loan pays one lump-sum payment at the time the loan is taken. After that, the borrower repays the loan over a set period, and the interest rate is fixed. Loan terms normally range from 5-10 years, with the borrower making the same regular monthly payment throughout the loan term.

A HELOC is a bit different. It works similarly, in that you’re borrowing against the equity you’ve built up in your home. However, you don’t borrow a single lump sum; you don’t even have to borrow a dime if you don’t want to.

Instead, a HELOC works more like a credit card. You’re authorized for a “draw period” of 5-10 years, during which you can borrow money as needed, up to your approval limit. This is followed by a 10-20-year “repayment period,” during which you can no longer borrow new money. Any money you borrow is usually repaid with a variable interest rate, but there are a few fixed-rate HELOCs available.

Pros & Cons of Home Equity Loans

As with any other loan, home equity loans have their own benefits and drawbacks. Before you start borrowing money, it’s important to weigh these factors. Here are some of the things you’ll want to take into consideration.

Pros of Home Equity Loans

A home equity loan is a quick and easy way to get cash. For a responsible borrower, it’s a lower-interest option than most other loans. As long as you have a steady job and no concerns about income loss, you’ll be able to take advantage of these low rates, as well as the valuable mortgage interest tax deduction.

In addition, a home equity loan is normally easy to obtain. Because it’s secured by the home itself, the lender is taking relatively little risk. As long as you meet the credit score and income requirements, almost anyone can qualify.

The low interest rate isn’t just useful if you’re taking the loan to pay cash expenses. It’s also useful if you want to pay down other, higher-interest debts. In fact, the number one reason people take a second mortgage is to pay off credit card debt.

A home equity loan is a good option if you have a specific goal in mind, and you know how much you need to borrow. Because you’re borrowing a lump sum, you can immediately take that money and use it for something else. For this reason, a lot of people take out home equity loans to pay for home improvement, college, and other major expenses.

To sum up the benefits:

  • Home equity loans are easy to qualify for.

  • They have a fixed interest rate, and the rate is relatively low.

  • The loan term is long, so you have time to pay it off.

  • You receive a single lump-sum payment.

  • Your monthly payments are fixed and predictable.

  • You can use the money for anything you want.

Cons of Home Equity Loans

The main drawback of a home equity loan is that it can turn into a trap. Let’s say you have tens of thousands of dollars in credit card debt, and you take a second mortgage to pay it off. That’s all well and good; you’ve lowered your interest rate, saving yourself thousands of dollars in payment.

Unfortunately, many people don’t stop there. With their newly-paid-off credit cards, they go on another spending spree. In fact, this happens so often that lenders even have a name for it: reloading.

The problem with reloading is that you’re constantly taking on more debt. Paying your credit cards with a home equity loan doesn’t make the debt go away – it just lowers the interest. You’re still making monthly payments. If you take on more credit card debt on top of that, that’s even more debt.

This often leads people to take out higher-interest home equity loans for more than the home’s value. Because these loans aren’t fully secured, they have higher interest rates than traditional second mortgages. It’s easy to see how this could lead to a vicious cycle of spending, debt, more spending, and more debt.

Whenever you apply for a home equity loan, consider how much you really need to borrow. Since you can only take one lump sum, it can be tempting to borrow more. But think about your current financial situation. If you were having trouble with debt to begin with, can you really afford to pay back a larger loan?

Summing up the drawbacks:

  • If you still have a primary mortgage, you’ll be making two mortgage payments.

  • If you default, the lender could foreclose on your home.

  • You can’t sell your house until the loan has been paid off.

  • You’ll have to pay closing costs to secure the loan.

  • Reloading can lead to a vicious cycle of debt./p>

Example of a Home Equity Loan

Let’s say you just purchased a new car. After the down payment, you owe $20,000, with an interest rate of 12% and a repayment term of five years. Your monthly payment would be $445 before taxes and fees, and you’d pay $26,729 over the life of the loan.

Now, let’s say you can take out a $20,000 home equity loan and use it to pay off the car loan. This new loan has the same five-year repayment term, but the interest rate is only 6%. Your monthly payment would be reduced to $386, and you’d pay $23,207 in total. That’s a significant savings, so it makes sense to take the second mortgage.

Summary

A home equity loan is a great way to get quick cash for unexpected expenses. Compared to taking most other loans, you’ll pay a much lower rate of interest. Of course, it’s important to exercise caution; like a mortgage, an unpaid home equity loan can result in foreclosure. But as long as you’re not living beyond your means, this is often the best type of loan you could take.


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