Home Equity Loan: A Simplified Guide to Borrowing Against Your Home Equity

A home equity loan is a loan you take out against the equity you already have in your home. It gives you fast access to cash, with a predictable, long-term repayment schedule. It’s one of a few options homeowners can use to access some of the equity they’ve built in their homes without selling. Other options include a home equity line of credit (HELOC) and a cash-out refinance.

What is a home equity loan?

A home equity loan gives you a lump sum of cash, which you pay off with consistent monthly payments in addition to your current mortgage payment. The length of the loan varies, but 20-years is common. Home equity loans usually have fixed rates and because your home serves as collateral, rates are typically lower than unsecured loans, like credit cards. Home equity loans are also called second mortgages or home equity installment loans.

What is home equity?

Home equity is the difference between the amount you owe on your mortgage and what your home is worth. You can build home equity in three ways: By making your monthly principal payments, by the local real estate market appreciating and by completing valuable home improvements.

Here’s an example. Let’s say you own a house valued at $300,000. You put down $30,000 when you bought it and since then, you have paid $30,000 in mortgage principal. That means you have $60,000 in equity ($300,000 home value minus $240,000 still owed).

How does a home equity loan work?

A home equity loan functions much like a mortgage where you’re provided a lump sum up at closing and then you begin repayment. Every month, you’ll make the same payment amount, which is a combined principal and interest payment, until your loan is paid off. In the first half of the loan, you’ll make interest-heavy payments and then principal-heavy payments in the second half — this is called amortization.

How much can you borrow with a home equity loan?

The amount you’re able to borrow depends on your current home equity. The calculation lenders use to determine your loan amount is called a loan-to-value, or LTV, ratio. It’s expressed as a percentage, calculated by dividing your outstanding loan balance by the appraised value of your property.

Most lenders will allow you to borrow up to 80% LTV, but some will let you go as high as 90%.

NOTE: In case you borrow 90% LTV, retaining only 10% equity in your home will not typically trigger private mortgage insurance because a home equity loan charges higher rates to cover the lender’s risk.

Using the same example above, of a home with $60,000 in equity and a remaining balance of $240,000, let’s say you want to use some of that equity to make home improvements. Here’s what various LTV limits would allow:

These rates do not include interest payments, which are an important factor in how much you pay each month.

How long does a home equity loan take to get?

To acquire a home equity loan it takes between two and six weeks from application to close, compared to four to six weeks for most other loan closings. The home equity loan closing process is comparatively quick.

How long does a home equity loan take to repay?

Repayment of a home equity loan takes anywhere from five to 30 years, but the most common home equity loan term is 20 years. Talk to your lender to decide on a repayment term that works best for you.

What can you use home equity loan funds for?

You can use the funds you borrow from your home equity for any purpose, but it’s prudent to have an important goal for the money, as it can be tempting to use it to cover everyday expenses and make unnecessary purchases that you’ll have to pay back, with interest.

Can you use a home equity loan for a down payment?

You can use a home equity loan to access the equity in your current home to apply toward a down payment on your next home. This is a popular way to allow you to make a sizable down payment on a new home without needing to sell your current home concurrently.

Keep in mind that your overall debt (including the home equity loan) will be factored into your debt-to-income ratio (DTI), which can affect your interest rate and eligibility for your new mortgage.

When your old home sells, the proceeds will first pay off your remaining mortgage balance, then your home equity loan. Any money left over will be distributed to you in cash.

Can you use a home equity loan to pay off your mortgage?

A home equity loan can be used to pay off your current mortgage, but this only makes sense if you can get a lower interest rate (as well as factoring in closing costs and fees) than your current mortgage. If you can, this will allow you to save on interest and thereby reduce your monthly payment.

How to get a home equity loan?

Applying for a home equity loan is similar to applying for a mortgage or refinance. Here are the general steps you’ll follow:

1. Check your home equity balance.
2. Compare rates, fees and repayment terms on lender's Loan Estimate.
3. Apply with the lender of your choice.
4. Carefully review disclosure documents and agree to the home equity loan terms.
5. Complete a home appraisal if requested by your lender.
6. Support the underwriting process by compiling documents.
7. Sign and close the home equity loan.
8. Access your lump sum funds immediately.

Home equity loan requirements

Qualifying for a home equity loan requires more than just sufficient equity. You’ll also need to meet a wide range of qualifications based on your credit history and income. Here are some general requirements:

• Credit score: 620+ and consistent payment history on your current loan
• DTI: 43% or less
• Equity: Retain at least 20% equity in your home after the home equity loan
• Income: Proof of sufficient income or assets

NOTE: It is possible to have a home equity loan and HELOC on the same property as long as you have enough home equity to qualify for both programs.

Home equity loan closing costs

Closing costs range between 2% and 5% of the loan amount, which is typically lower than closing costs on a purchase mortgage and even slightly lower than closing costs on a cash-out refinance.

Common home equity loan fees include an appraisal fee generally between $300 and $400, notary fees between $50 and $200, and title search fees of $100 or less. You’ll also pay a loan origination fee that’s a percentage of the total amount you’re borrowing.

Keep in mind that each lender charges different amounts for home equity loan fees, and some lump multiple types of fees together. Some lenders even offer no closing cost home equity loans, which prevent upfront costs but can result in a higher interest rate for the life of the loan.

Home equity loan rates

Home equity loan interest rates are almost always fixed, which means they’re stable throughout the life of your loan. They’re generally higher than cash-out refinance rates, but lower than personal loans or credit cards.

Today’s mortgage rates vary with market conditions, but the rate you’re offered also depends on the riskiness of your financial profile. A lender must assess whether they believe you’ll repay the home equity loan on time. Lower risk borrowers earn lower interest rates. Mortgage “points,” or loan discount points, are prepaid interest that reduce your rate on most loan types. Points cost more upfront, but may make sense long-term to save on interest.

Shop around and talk to at least two to three lenders about a home equity loan, and compare the overall cost for each loan to find the one that makes the most financial sense for you given today’s rates.

If you’re using a home equity loan to “buy, build, or substantially improve” your property, the interest you pay may be tax deductible. This can have a big impact on the affordability of your home equity loan, so be sure to talk to your tax professional up front.

Pros and cons of home equity loans

No one financial product is right for every homeowner. Here are a few of the key advantages and disadvantages of home equity loans.

Advantages of home equity loans

Fast access to equity: A home equity loan puts cash in hand within two to six weeks.

Easier to qualify for: A home equity loan can be a bit easier to qualify for than a cash-out refinance.

Lump sum payout: You’ll receive a sum of cash you can use immediately, then repay slowly over time.

Flexible use: There are no limitations to what you can use the money for, whether you’re consolidating debt, renovating, paying college tuition or something else.

Home equity loan disadvantages

Risk of losing your home: Since a home equity loan is secured by your home, you could lose your home if you don’t make the required payments.

Reduces your home equity: You’re withdrawing your home equity, with interest, and spending it elsewhere. Make sure it’s worth the overall cost, as you’re effectively reducing your home equity.

Reduces resale profit: If you decide to sell your home part way through paying back your home equity loan, your profit will be reduced, since your loan must be paid off at closing. You may also have to pay a cancellation or early pay-off fee.