As a homeowner, you’ll build equity in your home with each mortgage payment. When you need to fund a big expense, a home equity loan can help you tap into this source of funds.
But it’s important to understand exactly how a home equity loan can impact your finances. We’ll take a closer look at how a home equity loan works and help you understand what’s required to get one.
What is a home equity loan?
A home equity loan, otherwise known as a second mortgage, allows you to access the equity you’ve built in your home by using your home as collateral. When you take out a home equity loan, you’re agreeing to an additional loan payment on top of your existing mortgage loan for the life of the loan.
Home equity loan rates
Home equity loan rates vary based on the lender, loan amount, loan term, and your specific financial circumstances. A borrower with a good credit score can lock in a better rate than a fair credit borrower.
In 2022, home equity loan rates for a 15-year fixed term have ranged from 2% to 12%. Home equity loan rates are typically higher than currently available mortgage rates, as they are considered second mortgages and pose more risk for lenders.
Home equity loan requirements
The exact requirements for a home equity loan vary based on the lender. But in general, you’ll need to check the following boxes:
- Existing home equity: You’ll need to have a substantial amount of equity in your home. Most lenders prefer to lend no more than 80% of the equity in your home, meaning you’ll need more than 20% equity available to borrow against. To calculate the equity you’ve built in a home, subtract your existing mortgage balance from the market value of your home.
- Good credit score: Lenders often expect a good credit history from home equity loan borrowers. It’s possible for borrowers with a score in the mid-600s to get approval, but most lenders prefer a credit score above 700.
- Low debt-to-income ratio: A low DTI assures lenders that you can afford to make the payments based on your income. Typically, a DTI lower than 43% is acceptable but a lower DTI increases the strength of your application.
If you are considering a home equity loan, the eligibility requirements are similar to a traditional mortgage. Ultimately, lenders want to make sure you can afford the payments — in addition to your current mortgage — for the duration of the loan term.
What can a home equity loan be used for?
Home equity loans offer an opportunity to fund a wide range of needs. As a borrower, there are usually no constraints on how you can use the funds. But typically, homeowners take advantage of home equity loans to fund a major expense.
A few popular uses include:
- Home improvements
- Medical bills
- A new business
- High-interest debt
A common use for home equity loans is debt consolidation. Home equity loans tend to offer low rates compared to high-interest credit card debt. As a result, some homeowners use this loan option to pay off credit card debt and “consolidate” down to one lower-interest loan.
How does a home equity loan work?
A home equity loan is often referred to as a second mortgage. So, it’s not surprising that the process of taking out a home equity loan may feel similar to taking out a regular mortgage.
Lenders will use your existing home’s equity as collateral to protect against the possibility of you defaulting on the loan. With that, most lenders won’t let you borrow more than 80% to 90% of the home’s appraised value. But your unique situation will have an impact on how much you can borrow.
After receiving a lump sum, you’ll be responsible for making principal and interest payments for the loan term. Home equity loans typically have fixed interest rates and stable payments over the loan term, unlike home equity lines of credit (HELOCs), which often have variable rates. Home equity loans are also “fully amortized,” meaning your loan will be zeroed out at the end of the fixed payment period.
If the borrower defaults on the loan, the lender can seize the home to cover the remaining debt.
Other ways to access home equity
Home equity loan vs HELOC
A HELOC, or home equity line of credit, is a revolving line of credit. Instead of receiving an upfront lump sum, you’ll have access to a credit line to spend as needed. You can draw down funds when you need to up to the credit limit. Typically, a HELOC involves a draw period followed by a repayment period and a variable interest rate.
In contrast, a home equity loan involves a lump sum upfront and fixed monthly payments. You won’t have the option to easily pull out more funds as needed. But the fixed interest rate and set repayment installment schedule mean you know exactly how much interest you’ll be paying and when the loan will be paid off.
Home equity loan vs cash-out refinance
A home equity loan involves taking out a second loan, while a cash-out refinance replaces your existing mortgage with a new mortgage. With a cash-out refinance, the outstanding balance of your new mortgage is paid off and you agree to a new term and interest rate. At the end of the day, cash-out refinancing means you’ll just have one payment after accessing a lump sum from your home equity.
Some homeowners prefer cash-out refinances as they can offer lower interest rates than a second mortgage. However, if current mortgage rates are above your existing mortgage rate, replacing your home loan with a cash-out refinance may not be ideal.
Home equity loan FAQ
What is a home equity loan?
A home equity loan, or second mortgage, allows you to borrow against the equity you own in your home. You can use the funds from a home equity loan for anything from home renovations to education costs.
Where can I get a home equity loan?
Homeowners can access home equity loans through banks, credit unions and online lenders.
How do I apply for a home equity loan?
Before you start the application process, shop around for a home equity loan lender that offers the best terms and rates. Once you find the right lender, you’ll submit an application that includes information about your home, employment and credit history.
Is a home equity loan a mortgage?
A home equity loan is a type of mortgage loan that allows you to access cash, using your home as collateral. If you default on a home equity loan, the lender may seize your home to recoup its costs.
Are home equity loan rates higher than mortgage rates?
Typically, home equity loan rates are higher than regular mortgage rates. That’s because a home equity loan is considered a second mortgage.
This is because, in the case of default, the primary lender claims the first lien, which means the risk assumed by the second lender is greater than it would be for a first mortgage.
What is the interest rate on a home equity loan?
Home equity loan interest rates vary widely based on your unique situation and the market conditions. A borrower with a good credit score can lock in a better rate than a fair credit borrower.
What is the monthly payment on a $100,000 home equity loan?
The monthly payment on a $100,000 home equity loan varies based on the interest rate and loan term. But let’s say that you take out a 10-year home equity loan with a 5% fixed rate. With that, you’d make monthly payments of $1,061.
Do home equity loans hurt your credit?
Like all loans, home equity loans can help or hurt your credit score. If you make on-time payments, a home equity loan could improve your credit. But if you regularly miss payments, your credit score will suffer.
Is it good to borrow from home equity?
Whether or not it is good to borrow from home equity depends on your unique financial situation. For some borrowers, it may be more practical to take a personal loan or dip into a savings account, rather than tap home equity.
Typically, home equity loan rates are lower than high-interest credit card debt. With that, you could save by using a home equity loan when you might otherwise use a credit card. But a home equity loan uses your home as collateral, which means your home is at risk if you default.
How much money can you borrow on a home equity loan?
The maximum loan amount you can borrow varies based on the amount of equity you own in the home. In general, lenders won’t allow more than an 80% to 90% loan-to-value ratio (LTV). Keep in mind that LTV includes the balance on your existing mortgage. So your primary mortgage and second mortgage (home equity loan) cannot total more than 80-90% of your home’s value when combined.
How long do you have to pay back a home equity loan?
You can find home equity loan terms in the range of five to 30 years. As a borrower, you’ll have to decide what period of time works best for you.
Can you get a home equity loan with bad credit?
It’s more challenging to get a home equity loan with bad credit, but it may be possible. Since you are using your home as collateral, lenders may be more willing to work with bad credit borrowers. Keep in mind that lower credit scores lead to higher interest rates on home equity loans.
Can I use a home equity loan to buy another house?
Depending on the amount of home equity you have, it’s possible to use a home equity loan to access cash to buy another home.
Are there closing costs on a home equity loan?
Yes, you should expect to pay between 2% to 5% of the loan balance in closing costs for a home equity loan. The closing costs may include origination fees, application fees, and more.