Home equity loans: what to know

Home equity loans (HELs) allow you to tap into the equity you have in your property without pounding a for-sale sign into your front yard. Equity is the difference between what you currently owe on your mortgage and your home’s current appraised value.

If you need a little extra cash, using your home’s equity can be a good idea if you’re comfortable with the risks

• What are home equity loans?
• HELOC vs home equity loan
• Pros of home equity loans
• Cons of these products
• How to get home equity loans
• Frequently asked questions

What are home equity loans?

Home equity loans, also known as second mortgages, use the equity you’ve built up in your home as collateral for new loan funds. Similar to mortgages, lenders dispense your loan in one lump sum that you typically repay in monthly installments. The interest rates are usually fixed, which means you make the same payment each month. 

Generally, lenders require a good to excellent credit score — preferably over 620 — and a low debt-to-income ratio to qualify for the best rates and terms. It’s also preferred that you have a loan-to-value (LTV) ratio of at least 80% (though you could be eligible with a 100% LTV). Your LTV is calculated by dividing your outstanding loan balance by your property’s current appraised value.

Lenders use your LTV to determine how much risk they may take on when writing a loan. So, the lower the number, the better. 

Most lenders let you borrow between 75% and 80% of your home’s equity, which can be used for almost any reason, like making home improvements, covering an emergency expense, paying for college, and more. For example, if you have $150,000 in equity, $112,500 to $127,500 may be available to you, depending on your credit profile. 

You can opt for a longer repayment term on a home equity loan, which can lower your payments, or a shorter term with higher monthly payments. Either way, you have access to your money right away. 

However, your home is used as collateral for the loan. That means you risk losing your house to foreclosure if you can’t make your payments or default on your loan. Before taking out a HEL, make sure you have the income and budget to afford your payments. 

HELOC vs home equity loan

Instead of opting to take out one lump sum, a home equity line of credit (HELOC) lets you borrow from your home equity on demand, as you need the money. HELOCs are similar to a credit card as they provide a revolving line of credit to be used as needed. 

The credit limit you can tap into is determined by how much equity you have in your home. The term or number of years you can access the equity is called the draw period. 

How is a HELOC similar to a home equity loan?

Both a HELOC and home equity loan use the equity in your home to secure the loan or line of credit. The interest rates are also often better than those of personal loans, most credit cards, and other unsecured debt. You can use the money from a HEL or HELOC for various purposes, such as consolidating debt, renovating your home, or even paying for a wedding. 

The downsides to both a HELOC and a HEL are the same. The loan depletes your home’s equity. Plus, you risk losing your home if you can’t handle repayment on either financing option.

How is a HELOC different from a home equity loan?

HELOCs differ most significantly from HELs in how you access the funds.

Instead of one lump sum with a HEL, you draw on HELOC’s  line of credit as needed, up until your credit limit. Interest is also only applied to the amount you borrow rather than the whole amount.

Interest rates on a HEL are fixed, but interest rates on a HELOC are variable. That means your HELOC rate could increase or decrease after your funds are disbursed. So, the amount you owe each month can fluctuate, making it more difficult to budget.

Also, if a HELOC balance remains after your draw period, you’ll enter a fixed repayment period, which is typically about 20 years. Overall, a HELOC is best for expenses you can repay quickly rather than over many years.

Pros of home equity loans

There are many benefits to home equity loans, such as: 

• Lower interest rates: Because you use your home as collateral, you lower the risk to the lender so you may qualify for a lower interest rate. 
• Large loan amounts: If you have sufficient equity in your home, the amount of money you can borrow can be considerable.
• Tax break: You may be able to deduct the loan’s interest on your taxes.
• Fixed payments: You pay the same monthly payment over the life of your loan. This fact makes it easier to set a budget and stick with it.
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• Easy access to funds: Since you receive your money in one lump sum, you readily have the financial assistance you need.

Cons of home equity loans

Besides the many pros of HELs, there are a few disadvantages, such as:

• Using your home as collateral: You can lose your home via foreclosure if you miss payments for 120 consecutive days or default on your loan.
• You might need to pay for an appraisal
• Fixed interest rates: Fixed rates can be both a plus and a minus. If interest rates fall in the market, you may end up paying more than you would with an adjustable rate loan. 
• Stiff eligibility requirements: Many lenders require a good credit score and low debt-to-income ratio (DTI) to offer a loan with the best terms. Your DTI compares your total monthly debts with your gross monthly income. The lower your DTI the better. Many lenders prefer a DTI below 43% or lower.
• Paying two mortgages: Since you are taking out a second mortgage with HELs, you’ll be paying that back on top of your current mortgage. Not to mention, if you decide to sell your home after getting an HEL, you’ll have to pay off the entire balance of the loan once you close — as well as the remaining balance of your primary mortgage.

How to get home equity loans

Applying for a home equity loan is similar to applying for a mortgage or mortgage refinance. Although it may vary  among the top home equity loan lenders, in general, these are the steps you’ll take:

1. Check the equity balance you have available on your home. This is a relatively easy step you can complete by reviewing your most recent mortgage statement or calling your mortgage broker or lender.
2. Confirm affordability: Use a HEL calculator and create or update your budget to ensure you can realistically afford your potential new loan payments.
3. Shop around. Compare rates, fees, and terms from your current lender as well as other lenders, so you’re confident you receive the best possible deal.
4. Apply with the lender of your choice. You’ll have to provide both financial and personal information during this step, so have those documents ready will  save time. Be aware that your credit score might drop temporarily after applying. However, it would likely increase as your loan is funded and you begin making on-time payments.
5. Review the disclosure documents. If you have questions, now is the time to ask for clarity. If you are happy with your disclosure terms, you can agree to the HEL.
6. Check on an appraisal. If your lender requires a home appraisal to assess your home’s worth, now is the time to schedule that appointment.
7. Prep your paperwork. Compile any documents required to support the underwriting process.
8. Close on your HEL by signing the documents. However, review the documents carefully first. If the paperwork terms aren’t to your liking, you may be able to exercise your right of rescission, meaning you have the right to cancel a home equity loan — and without penalty — within three days.
9. Collect your lump sum amount. Utilize the funds as needed while making sure to make your monthly payments on time.

Frequently asked questions

What are the average interest rates for home equity loans? 

The January 26, 2023 rate for a 15-year, $50,000 home equity loan, according to U.S. Bank, was 7.95%.

What should you use a home equity loan for?

You can use your HEL for almost anything, from consolidating high-interest debt and paying off medical bills to financing your wedding. 

What are alternatives to home equity loans?

Here are other options beyond HELs that may be worth exploring further.

Cash-out refinance: Like home equity loans, a cash-out refinance takes funds from your home equity. However, it works by replacing your existing mortgage loan with a new larger loan and giving you the difference in cash. With this new loan comes a new term and interest rate that may be lower than the rates that were around at the time of your home purchase. But remember that whatever interest rate you qualify for, it will apply to your entire mortgage balance, not just the cash you’re taking out of your house.

• Personal loan: Many personal loans are unsecured, which means you don’t put up collateral to secure your loan. They can be used for almost any purpose, but interest rates can be higher than on most home equity loans.  
• Credit card: Credit cards offer a line of credit that is more like a HELOC than a HEL. You can use a credit card for almost any purpose, but interest rates can be high. Only secured credit cards (for borrowers with poor credit) require collateral. 

What are the eligibility requirements for home equity loans?

• A minimum credit score of 620: The better your credit score, the more likely you are to qualify for the best rates and terms on your HEL. You might still be in good favor with a lower credit score if you’ve built up a reasonable amount of equity and have a low debt-to-income ratio. Just know that your interest rate could possibly be higher.
• No less than 20% equity in your home: At least 20% equity in your home means you have an 80% loan-to-value ratio, which is squarely in the middle of what most lenders prefer. 
• Stable income: During the application process, your lender will ask for proof of income (likely for the past two years), which might include pay stubs and tax returns. 
• Low debt-to-income ratio: Lenders want to see a low DTI. Calculate your DTI by adding up your monthly debt payments and dividing that number by your gross monthly income.