How Does A Home Equity Loan Work?
A home equity loan works a lot like a regular mortgage — you can borrow money in a lump sum and make predictable monthly payments at a fixed rate. If you’ve paid down your loan balance or noticed home values jumping in your area, you may be able to convert your home’s equity into cash to use for everything from paying off high-interest-rate credit cards to renovating your home.
We’ll cover the ins and outs of home equity loans to answer the question: How does a home equity loan work?
What is a home equity loan?
A home equity loan is a type of second mortgage that allows you to borrow against a portion of your home’s equity and use the cash for any purpose. It’s called a second mortgage since it’s usually attached to a home that’s already secured by a first mortgage. If you default and the lender forecloses, the home equity loan is repaid after the first mortgage.
Home equity loan funds are disbursed in one lump sum that’s repaid in fixed monthly installments. Loan terms can be as short as five years or as long as 30 years.
How a home equity loan works
The moving parts of a home equity loan are similar to those of a fixed-rate first mortgage:
- The lender qualifies you based on your income, credit scores and total debt.
- An appraisal is ordered to verify your home’s value and finalize your home equity loan amount.
- You choose a fixed rate and the loan term and pay closing costs, which can be deducted from your loan or paid out of pocket.
- The entire home equity loan balance is disbursed in a lump sum.
How much home equity can I borrow?
Most home equity lenders only allow you to borrow up to a certain percentage of your home’s value, known in lender language as your loan-to-value (LTV) ratio. Although some lenders may offer high-LTV home equity loans that allow you to borrow all or almost all of your home’s equity, most companies offering home equity loans let you tap up to 85% of the home’s value.
- Multiply your home’s value by 85% (0.85): $350,000 x 85% = $297,500
- Subtract your loan balance from the result: $297,500 – $250,000 = $47,500
- Your maximum home equity loan amount: $47,500
How much are home equity loan closing costs?
You should budget between 2% and 5% of your home equity loan amount toward closing costs. Check with your local bank or credit union — it may discount your rate or costs if you tie your home equity loan to a bank account.
What are rates on home equity loans?
Home equity loan interest rates rise and fall with financial markets just like interest rates for a first mortgage. You can check current home equity loan rates online or by calling home equity lenders in your area.
What is home equity?
Home equity is the difference between your home’s value and your loan balance. The amount of home equity you have varies depending on how much home prices fluctuate in your area and how fast you pay off your loan balance. For example, you build home equity much faster with a 15-year versus a 30-year fixed-rate loan because more of your payment goes toward the loan balance.
How to calculate equity in your home
You can calculate your home equity easily by following the steps below.
- Get an estimate of your home’s value. Try an online home value estimator, or give a real estate agent a call to do a comparative market analysis for you. Just remember: Home equity lenders generally require a home appraisal from a licensed appraiser, so your numbers could change if your estimate is too high or low.
- Check your current loan balance. Grab your current monthly mortgage statement to determine your existing home loan balance.
- Subtract your loan balance from your home value estimate. This result is how much home equity you have.
Here’s a quick example, assuming your home is worth $350,000 and your loan balance is $250,000.
$350,000 home value
($250,000 loan balance)
___________________
$100,000 home equity
Why should I get a home equity loan?
Common reasons you might choose a home equity loan include:
- You have a low rate on your current mortgage and don’t want to refinance it.
- You’d prefer a fixed-rate loan with predictable monthly payments.
- You’re making renovations with a set timeline for finishing them.
- You’re paying off high-interest-rate revolving debt.
- You want to avoid mortgage insurance with a piggyback loan.
- You’re buying a rental property, starting a business or covering higher education costs.
Home equity loan requirements
The guidelines for home equity loans are more stringent than those for a cash-out refinance loan. Some specialty home equity lenders may set different standards, but the most common requirements to qualify are:
A maximum 43% DTI ratio. Home equity lenders divide your total debt by your income before taxes — a calculation called your debt-to-income (DTI) ratio — and generally set the maximum at 43%.
A minimum 620 credit score. You’re likely to get a much higher rate for a home equity loan with the minimum score, and home equity lenders may require a minimum between 660 and 680. Lenders may limit your maximum LTV ratio with lower credit scores, which will reduce your maximum home equity loan amount.
A maximum 85% LTV ratio. Some specialized home equity lenders set LTV ratios at 90% or higher, while most follow the 85% LTV maximum.
Owner occupancy. The lowest rates and highest LTV ratio loan amounts are offered on a loan for a home you live in full time. Although home equity loans are available for investment properties and second homes, you’ll pay a higher rate and be restricted to a lower LTV ratio.
Home equity loan vs. line of credit (HELOC)
Another popular loan for tapping your equity is the home equity line of credit, or HELOC for short. A HELOC works like a credit card tied to your home’s equity — you can use it as you want, pay it off and reuse it for a set time called a draw period. However, once the draw period ends, the balance is due in installment payments. The table below gives you a quick glance at reasons to choose one over the other:
| A home equity loan makes sense if: | A HELOC makes sense if: |
|---|---|
| You want a fixed rate and stable payment | You don’t need all the funds at once |
| You need all the funds at once | You want to pay off and reuse the funds |
| You want a full principal and interest payment each month | You prefer the flexibility of an interest-only payment option |
How to apply for a home equity loan
If a home equity loan is in your future, here’s how to apply.
- Shop at least three to five lenders and review the loan estimates.
- Provide your income and current mortgage info, and have your credit pulled.
- Have your home cleaned up and ready for the home appraisal.
The process generally takes two to four weeks, and you receive your funds after a mandatory three-business-day waiting period once you’ve signed your closing documents.
Frequently asked questions
Yes, if it helps you improve your finances. Avoid the temptation to use your home like an ATM — you could lose your home if you can’t make the payments and the lender forecloses.
You may see a brief dip in your score when you apply for the loan.
Yes, bad credit home equity loans are available from some lenders. Be prepared for a much higher rate and less borrowing power than you’d see with loans for high-credit-score borrowers.