What is a Home Equity Loan and How Does It Work?

A home equity loan allows you to tap into your home equity to borrow money.

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If you are a homeowner and need money, you can leverage your house through a home equity loan. A home equity loan allows you to access funds from the equity in your home. They often come with favorable interest rates, making them an appealing option for those who need funds for various purposes. We will break down what home equity loans are, how they work, and their pros and cons.

Key Takeaways

  • A home equity loan, also known as a second mortgage, allows homeowners to take out a loan using their house as collateral.
  • While home equity loans have lower interest rates and may offer potential tax benefits, they can also exacerbate debt burden.
  • Before taking out a home equity loan, you should shop around and check your credit and debt-to-income ratio.

Understanding Home Equity Loans

A home equity loan, often referred to as a second mortgage, enables homeowners to borrow money by using the equity in their home as collateral for a loan. In other words, you are securing the loan with your property. Equity is the current market value of your property minus any outstanding mortgage balance.

Typically, these loans have a fixed interest rate, meaning the interest rate will not change. While repaying the loan, you will still need to continue making your mortgage payments, hence the nickname “second mortgage.” You can use the funds from the loan for various purposes, such as consolidating debt, financing home improvements, covering education expenses, or even paying for a vehicle.

How a Home Equity Loan Works

Borrowers will receive a single lump-sum payment that they will pay back in fixed installments over a predetermined period, typically 10 to 30 years. These installments consist of both the principal amount and the interest charges, providing predictability in the repayment period. The shorter your repayment period, the more you will need to pay each month. For instance, a 10-year loan will have a higher monthly payment than a 15-year loan. However, you will pay less interest over time when you opt for a shorter repayment period.

The amount you can borrow through a home equity loan is based on a combination of factors, including your home’s appraised value, the existing mortgage balance, and your creditworthiness. As with a conventional mortgage, if you do not repay the loan, the lender may use your home to repay your remaining debt. If property values decline, you may end up owing more than your home is worth, leading to other potential challenges.

Before taking out a home equity loan, weigh all your options and compare lenders to find the best terms. You should also determine your budget since the amount you qualify for may be more than what you actually need. If you have other existing debt, create a plan to figure out how to incorporate the new loan into your monthly expenses.

5-Year Home Equity Loan Rates (60 Months)

10-Year Home Equity Loan Rates (120 Months)

15-Year Home Equity Loan Rates (180 Months)

20-Year Home Equity Loan Rates (240 Months)

30-Year Home Equity Loan Rates (360 Months)

Pros and Cons of a Home Equity Loan


Home equity loans provide a straightforward way to access a substantial amount of money. They are typically easier to qualify for than other types of loans, such as personal loans. Since the loan is secured by your house, the application process is fairly straightforward, though it can still be lengthy. The lender will run a credit check and order an appraisal of your home to gauge your creditworthiness and combined loan-to-value (CLTV) ratio.

The interest rates are fixed and generally much lower than those of credit cards, personal loans, and other consumer loans. You can also choose longer terms, allowing you to make lower monthly payments. There are no restrictions on how you use the money, whether it’s for remodeling, higher education, debt consolidation, etc.

Home equity loans can potentially provide tax benefits if you use the funds for home improvements or renovations. In some cases, the interest paid on the loan may be tax-deductible. Additionally, if your primary mortgage has a favorable interest rate, you don’t have to give that up.


One of the main issues with home equity loans is that they can tempt borrowers with a history of overspending, borrowing, and spiraling deeper into debt. This phenomenon, known as “reloading,” involves using a home equity loan to pay off existing debts and unlock additional credit, which is often used for further spending. This cycle can lead to a growing debt burden that becomes increasingly challenging to manage.

If you take out a loan exceeding the home’s value, you can face higher fees. Since the loan isn’t fully secured by collateral in these cases, lenders mitigate the added risk by imposing additional charges. Plus, the interest paid on the portion of the loan exceeding the home’s value is not tax-deductible.

Since you get a lump-sum payout, you may end up borrowing more than you need. This can lead to accumulating unnecessary debt and interest charges. Borrowing beyond your means or using the loan for non-essential purposes can increase the risk of default, potentially leading to foreclosure or bankruptcy.

A home equity loan adds a second mortgage payment to your financial obligations. Unlike other consumer loans, home equity loans often entail closing costs, adding to the overall expense of the loan. An appraisal generally costs between $300 and $400, notary fees are $50 to $200, and title search fees may be up to $100. You will also need to pay a loan origination fee.

If you decide to sell your home before paying off the home equity loan, the entire balance becomes due at the time of sale. This means you must settle the loan in full, along with the remaining balance of your primary mortgage, upon closing.

Home Equity Loan Requirements

Each lender has different requirements, but most borrowers will need at least 20% equity in their home, a verifiable income history for at least two years, and a credit score greater than 600 to get approved for a home equity loan. There are instances where you can get approved without meeting these requirements, but you may have to pay a much higher interest rate.

How To Get A Home Equity Loan

1. Get Your Home Appraised

To determine if you qualify for a home equity loan and how much you can borrow, a lender will get your home appraised. Depending on the lender, you can borrow up to 125% of equity, though most lenders will only allow you to borrow up to 80% to 90% of the available equity in your home.

To figure out the amount you can borrow, determine your loan-to-value (LTV) ratio. For example, if the lender allows you to borrow up to 80% of the equity in your home, you would subtract the remaining balance of your primary mortgage from 90% of the home’s appraised value. If your home is appraised at $800,000 and your remaining balance on your mortgage is $300,000, you can secure up to $640,000 if you obtain a home equity loan.

2. Calculate Your Debt-To-Income Ratio

Another factor lenders will consider is your debt-to-income ratio (DTI), which helps them determine your ability to take on more debt. To qualify for a home equity loan, many lenders want to see a DTI of less than 43%.

To calculate your DTI, divide your total monthly debt payments by the gross monthly income. First, add up all your monthly debt payments, including your mortgage, student loans, auto loans, credit card balances, etc. Then, divide that by your gross monthly income, which is how much you earn per month before taxes and deductions. Multiple the result by 100 to get the percentage. For instance, if your total debt is $2,000 ($1,000 mortgage + $500 car loan + $250 credit card debt + $250 student loans) and you earn $6,000 a month, your DTI would be 33.33%.

3. Check Your Credit Score

Your credit score also plays a major role in determining if you qualify for a home equity loan. Borrowers with high credit scores are considered more creditworthy and often get better interest rates and terms. You may be able to access more of your equity as well.

If you have a good amount of equity in your home and a low debt-to-income ratio, you may still be able to qualify for a home equity loan even if you have a low credit score. However, you may get charged a higher interest rate and more fees.

Alternative Options

Cash-Out Refinance

A cash-out refinance allows you to tap into the equity on your property by replacing your existing primary mortgage with a new one for a higher amount. Unlike a home equity loan, where you take out a second mortgage alongside the primary mortgage, a cash-out refinance streamlines the process by rolling the remaining balance of the existing mortgage into a new one with revised terms.

Typically, cash-out refinance loans offer more competitive interest rates compared to home equity loans. That is because of the order of repayment in case of default or foreclosure. The primary mortgage lender takes precedence in receiving payments, making it a lower risk for the lender. As a result, the borrower gets a more favorable interest rate.

When you get a cash-out refinance, you can choose a loan term between 5 and 30 years. The amount of equity you can withdraw depends on factors such as the property’s current value, the existing mortgage balance, and the lender’s policies. Once you get approved, you get the cash upfront.


A home equity line of credit (HELOC) is another option that allows you to tap into your home’s equity. But, unlike a traditional home equity loan or cash-out refinance, a HELOC works more like a credit card. You’ll get an open line of credit secured by your house, allowing you to draw from a predetermined amount of money on an as-needed basis. The lender determines the maximum credit limit, often based on a percentage of the property’s appraised value and the outstanding mortgage balance.

HELOCs are best for financing ongoing projects, covering periodic expenses, or addressing unexpected financial needs. With a HELOC, you only pay interest on the amount you borrow, not the entire credit limit. Some HELOCs have interest-only periods during the initial draw period, typically spanning 5 to 10 years. After the draw period, borrowers enter the repayment phase, where they must start paying back both the principal and the interest.

A HELOC operates on a revolving basis. As you repay the borrowed funds, the credit becomes available to use again, providing ongoing access to your home’s equity. Typically, they come with variable interest rates, meaning your monthly payments may change over time. However, some lenders offer the option to convert a HELOC into a fixed-rate loan if you want more stability. The interest payments may also be tax-deductible if the funds are used for home improvements.

When is a Home Equity Loan the Right Choice?

Depending on your financial needs, a home equity loan can be a great choice. Here are a few scenarios where it may make sense to get a home equity loan:

  • Home Improvements: Using a home equity loan to fund renovations or home improvement projects can increase the value of your home.
  • Debt Consolidation: If you have high-interest debt, such as credit card balances, consolidating them with a home equity loan can lead to lower interest rates and more manageable payments.
  • Education Expenses: Financing higher education costs with a home equity loan can be more cost-effective than using high-interest student loans.
  • Emergency Expenses: In certain urgent situations, such as medical bills or home repairs, a home equity loan can give you quick access to funds.
  • Tax Benefits: If you use the funds for certain home improvements, you may qualify for tax deductions on the interest paid.

Before taking out a home equity loan, consider the following:

  • Your Repayment Ability: Ensure you have a stable source of income and can comfortably manage the additional monthly payments.
  • Long-Term Financial Goals: Assess how the loan aligns with your overall financial objectives, such as retirement planning or saving for other major life events.
  • Interest Rates and Terms: Compare the terms and interest rates offered by different lenders to secure the most favorable deal.
  • Use of Funds: Ensure that the funds are being used for a responsible and productive purpose and not for discretionary spending that could lead to further financial strain.
  • Risk Tolerance: Understand the potential risks involved, such as the risk of foreclosure if you default on the loan.
  • Consult a Financial Advisor: Seek advice from a financial professional or advisor to make an informed decision that suits your unique financial situation.

Things to Consider

Before doing an appraisal, you should ask for a good faith estimate (GFE), which outlines the estimated costs and terms. You should also have a strong sense of your credit score and home value. Paying for an appraisal is costly, and there are no refunds if you do not qualify.

If you are taking out a home equity loan to consolidate debt, run the numbers to ensure the new monthly payments will be lower than what you are currently paying on your existing debt. If home equity loans have lower rates, the new terms could lead to more interest charges over time if you opt for a longer term.

You may also want to talk to a qualified credit counselor or reach out to a non-profit credit counseling organization. They can advise you on how to manage your money and debts, create a budget, and give you free educational content. Avoid working with firms that ask for high upfront fees or overly idealistic promises, such as restoring your credit instantly. To get started, go on the National Foundation for Credit Counseling’s website or call (800) 388-2227.

The Bottom Line

If you have a good amount of equity in your home, a high credit score, and a low debt-to-income ratio, having a home equity loan may be a great financial choice for you. But, before choosing a home equity loan, compare different lenders and their loan programs, interest rates, fee structures, etc., to find the best option for you.

We are not financial advisors. The content on this website and our YouTube videos are for educational purposes only and merely cite our own personal opinions. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know that all investments involve some form of risk and there is no guarantee that you will be successful in making, saving, or investing money; nor is there any guarantee that you won't experience any loss when investing. Always remember to make smart decisions and do your own research!

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