How Does a Home Equity Loan Work?

How Does a Home Equity Loan Work?

For homeowners with enough equity, home equity loans have several advantages. But they also come with some risks that other types of loans don’t have. Here’s what you need to know about home equity loans, along with the pros and cons. 

What Is a Home Equity Loan — and How Does It Work?

Home equity is the amount of money that your home is currently worth, minus the amount that you currently owe on your mortgage. Essentially, this is the percentage of your home that you own yourself. The longer you’ve been paying your mortgage, the more equity you should have in your home (unless something went seriously wrong). When you take out a home equity loan, you use the equity that you build over time to secure your loan. 

“A home equity loan allows you to borrow a lump sum of money, which is collateralized by the equity in your home, and repay the loan in fixed monthly installments over a set period of time,” says Drew Feutz, certified financial planner and founder of Migration Wealth Management, LLC.

Home equity loans have fixed interest rates and fixed monthly payments. Loan terms can range anywhere from five to 30 years – once you pay off your loan, you own that portion of your home’s equity again, free and clear. Typically, you can borrow up to 80% of your home’s value, depending on how much equity you currently have. 

Home equity loans can be used for many purposes, including:

• Home renovations and home improvement projects

• Making large purchases, such as a vehicle

• Debt consolidation or debt repayment

• Paying for school or medical bills

• Emergency expenses

• Starting a business

If you need to consolidate debt, make sure you turn to a top debt consolidation company that will be able to help you manage your debt in an effective way. 

Pros of Home Equity Loans

Home equity loans have many key advantages:

• Home equity collateral. When you borrow against your home equity, you are using something with established value to secure a loan – which can potentially make it easier to qualify for a loan with favorable terms.

• Fixed monthly payments. Home equity loans have set monthly payments that never change, making them easy to plan for and budget-friendly. 

• Predictable interest rates. Home equity loans have fixed interest rates for the entirety of the loan, making them more predictable than forms of credit with fluctuating interest rates – such as credit cards. 

• Lower interest rates. Because they are secured by your home, home equity loans typically offer lower interest rates than unsecured forms of credit, like personal loans or credit cards.

• Extended repayment periods. You can get home equity loans with repayment terms that range from five years all the way up to 30 years. Longer repayment terms have lower monthly payments (though you will pay more in interest over the lifetime of the loan).

• Large borrowing potential. Depending on how much equity you have in your home, you might be able to borrow more than you could with other types of loans, like a personal loan.

• Potential tax advantages. “If you use the funds for home improvements, the interest is tax deductible, if you itemize your deductions. However, this is not relevant for most people as the vast majority of people do not itemize their deductions,” says Feutz. 

Cons of Home Equity Loans

There are also some disadvantages to home equity loans:

• Risk of foreclosure. Just like your mortgage, home equity loans use your home as collateral. If you don’t repay your loan, the lender could foreclose on the home, forcing you out. Foreclosure can also damage your credit, making it difficult to qualify for other loans in the future. 

• Equity requirements. You typically can’t get a home equity loan unless you have at least 20% equity in your home. Homeowners without that much equity will need to seek out an alternative. 

• Costs and fees. “Fees/costs associated with home equity loans will differ depending on the lender, but generally include origination fees for processing the loan, appraisal fees to determine the value of your home, [and] closing costs for a title search and to record the loan,” says Feutz. 

• Risk of going underwater. When you take out a home equity loan, you are essentially reducing your ownership stake in your home. If the real estate market slows down or home values drop, you have less equity as a buffer – and if your home’s value drops below the amount you owe, you could end up underwater on your loan, making it more difficult to sell your home. 

• Payback requirements upon sale of home. If you decide to sell your home before you pay back your home equity loan, you will have to use the proceeds from the home sale to pay off the loan in full. This reduces the amount of money you can pocket after the sale.

How Much Does a Home Equity Loan Cost?

Home equity loans aren’t free – you must agree to pay interest on them, over time, to access the funds. Several factors influence the interest rates you pay – including the Federal Reserve benchmark interest rate, your credit score, the amount of the loan, the repayment term, and more. 

See the table below for an example of how much you might pay for a $50,000 home equity loan, for both 10 and 15 year terms:

*Payments calculated using US Bank’s home equity payment calculator. We used a sample loan for a home in Anne Arundel County, Maryland with a home value of $500,000 and a remaining mortgage balance of $300,000, for a borrower with a credit score in the “good” range. 

You can also expect to pay fees when you take out a home equity loan, which can add up to around 3% to 6% of the total loan amount. The fees associated with home equity loans may include: 

• Loan origination fee. This is the fee you pay to the lender to cover the processing and funding portion of your home equity loan. 

• Appraisal fee. Your lender will want to assess the value of your home to determine how much equity you have, so you will need to pay for a home appraisal.

• Credit report fee. You can expect the lender to pull your credit report to check your creditworthiness and help determine your interest rate. Some lenders charge a fee for this step.

• Document fees. Fees range depending on how many documents you need and how many copies are required, but you can expect to pay for all the loan documentation involved. 

• Notary or signing fee. You will be required to sign documents with a notary service, which may cost an additional fee. 

• Title check fee. The lender will want to do a title check to make sure there are no liens or other issues with the title to your home, which may involve a fee. 

Home Equity Loan Requirements

“The borrowing requirements of home equity loans differ from lender to lender, but you need sufficient equity in your home to tap, you will be required to have a certain credit score determined by the lender, and you will be required to demonstrate stable income to support paying back the debt,” says Feutz. 

Requirements to take out a home equity loan include the following: 

• Sufficient equity in your home. Most lenders want you to have at least 15% to 20% equity in your home before you can borrow against it. Exact requirements depend on the lender. 

• Income. Lenders will look at your income to make sure you meet borrowing requirements and make enough money to repay the loan. You will need to submit proof of income which may include paystubs, W-2 forms, 1099 forms, tax returns, bank statements, and more. 

• Debt-to-income ratio. This ratio is the amount of your income that currently goes toward existing debts. Lenders prefer lower DTIs because that indicates you have more ability to make the payments on your home equity loan. Standards vary between lenders, but the Consumer Financial Protection Bureau recommends having a DTI of 36% or less (though some lenders may go up to 43% or higher). 

• Credit score. Credit score requirements depend on the lender, but most will look for a FICO score in the 600s range. According to credit bureau Experian, preferred credit scores for home equity loans are at least 680. 

• Homeowners insurance. Lenders won’t typically give you a loan unless you have homeowners insurance, which protects them against financial losses. Be prepared to provide proof of insurance when you apply for a loan. 

Home Equity Loan Alternatives

There are many alternatives to home equity loans that you can explore:

• Home equity line of credit (HELOC). HELOCs extend you a line of credit, up to a certain limit, with a variable interest rate and fluctuating monthly payments, using your home equity as collateral. You can withdraw funds from this line of credit as needed during the draw period, then pay it back over time (during the draw period, you may only be required to pay on the interest). Once the draw period ends, you start paying back the interest and the principal. 

• Personal loans. If you want an unsecured loan that isn’t tied to your home, look for a personal loan with a bank, credit union, or lender. These loans don’t require any collateral, but provide you a lump sum at a fixed interest rate that you pay back with a fixed month payment over a set period of time. Interest rates may range higher than home equity loans because the loan isn’t secured.

• Cash-out refinance. You can convert your home equity into cash by refinancing your existing mortgage, taking out a larger loan and using the proceeds to pay off your existing mortgage. You receive the leftover funds as a lump sum – but this will increase your monthly mortgage payment and loan balance, and only benefits you in the long run if you can get a lower interest rate.

• Credit cards with low introductory interest rates. If you need quick access to funding but want to avoid interest, look for a credit card with a 0% intro APR rate. You can charge what you need on the card, then try to pay off the balance before the promotional period expires and the regular interest rate kicks in. Keep in mind, the best credit card offers are reserved for borrowers with strong credit. 

Frequently Asked Questions

What Is the Difference Between a HELOC and a Home Equity Loan?

Home equity loans provide a one-time lump sum that you pay back like a traditional loan, with a fixed interest rate and fixed monthly payment. HELOCs provide ongoing access to funds as a line of credit – similar to a credit card – that you can draw from during the draw period, and pay back once the draw period ends. Both options require using your home equity as collateral. 

Is the Interest on a Home Equity Loan Tax-Deductible?

Home equity loan interest is tax deductible only when used to substantially improve your residence, because the IRS considers it home acquisition debt.  

What Are the Dangers of Equity Financing?

The biggest risk of equity financing is that your loan or HELOC is secured using your home. If you fail to repay your loan, the lender could foreclose on your home and you would lose your residence.