What is a home equity loan and how does it work?

A home equity loan is commonly called a second mortgage. It allows you to borrow against the equity you’ve built in your home, which is the difference between the home’s current market value and what you still owe on your mortgage. Once approved, you receive the funds in a lump sum, which you then pay back in fixed monthly installments over a set period.

Borrowers often use home equity loans to fund major life events, such as a wedding, or to consolidate high-interest debt. Because your home acts as collateral, these loans typically offer much lower interest rates than credit cards or personal loans. Plus, if you use the funds to renovate or improve your property, the interest may even be tax-deductible.

How does a home equity loan work?

A home equity loan allows you to borrow money by leveraging the equity you have in your home. You receive the full loan amount upfront, and pay it back in monthly installments over time — usually somewhere between five and 30 years. Most home equity loans have a fixed interest rate, so your monthly bill will not fluctuate over the loan term. 

It’s easy to confuse a home equity loan with a home equity line of credit (HELOC), but they are not the same thing. Although you are also borrowing against the equity in your home with a HELOC, you do not receive the funds in a lump sum upfront. Instead, a HELOC is similar to a credit card. You get approved for a maximum limit and can spend the money as needed over a set period. HELOCs also come with variable interest rates and less predictable monthly bills.

Home equity loan requirements

To qualify for a home equity loan, you must meet certain requirements. Here are the basic criteria:

• Home equity: In most cases, you must have at least 15 to 20% equity in your home. This means your combined loan-to-value (CLTV) ratio — the total of all your mortgage balances divided by your home’s current appraised value — should generally stay between 80 to 85%.
• Credit score: The minimum credit score needed for a home equity loan is usually around 620, but to get the best rates, your score should be 700 or higher.
• Debt-to-income (DTI) ratio: Most lenders favor homeowners with a DTI ratio of 43% or lower. Your DTI ratio is your monthly income compared to your monthly debt payments.
• Income verification: To get a home equity loan, you’ll need proof of current employment and a steady income history. 

Pros and cons of home equity loans

A home equity loan can help you access cash quickly if you need to cover a big expense. While home equity loans have benefits, they also have downsides. Here are some of the main pros and cons of home equity loans that you should consider:

Pros

• Predictable monthly payments: Home equity loan interest rates do not change. You’ll pay the same amount each month until the loan is paid off.
• Lower interest rates than unsecured debt: Because home equity loans are secured (your house is the collateral), they usually have lower interest rates than unsecured debt like credit cards.
• Potential tax deductions: If you use the money from a home equity loan to improve your home, you might be able to deduct the interest on your taxes.

Cons

• Your home is collateral: Since your home secures the debt, if you’re unable to pay the money back, you could face foreclosure.
• Closing costs and fees: Home equity loans typically have closing costs, including fees for the appraisal and title search. You’ll have to pay these fees out of pocket.
• Less flexibility if you need more money later: Because home equity loans provide a lump sum payment, it’s difficult to access more money later on, like you could with a HELOC or credit card.

Common uses for a home equity loan

Home equity loans have a variety of potential uses. Here are some of the most common ways homeowners use funds from a home equity loan.

• Home renovations: A home equity loan can be used on home renovations. For example, if you want to replace the roof or remodel your kitchen to increase the property value, you could use a home equity loan to avoid using your savings.
• Debt consolidation: Because home equity loans have low interest rates, they’re often used to pay off high interest credit card debt.
• Major life expenses: If you have a major life expense coming up, like a wedding, college tuition, or an emergency medical bill, a home equity loan can help you get the money quickly at a lower interest rate than a personal loan.
• Tax advantages: When you use a home equity loan to “buy, build, or substantially improve” your home, the IRS often allows you to deduct the interest paid on your taxes.

Home equity loan vs. HELOC

Home equity loans and HELOCs are similar, but they differ in a few key ways. Here’s a look at how a home equity loan and HELOC compare.

• Payout: A home equity loan provides all the money at once upfront, whereas a HELOC acts as a revolving line of credit that you can spend as needed.
• Interest rates: Most home equity loans have fixed interest rates that never change. HELOCs typically have variable interest rates that can fluctuate.
• Payments: With a home equity loan, you immediately start paying back the principal, plus interest. With a HELOC, you have the option to only pay interest during the draw period, which is usually the first five to 10 years. After that, you start making payments toward the principal.

Alternatives to a home equity loan

Home equity loans aren’t always the best solution. If you need to access money quickly, the best option depends on your situation and financial needs. Here are some alternatives to consider.

• HELOC: A HELOC can be a good choice if you want the flexibility of a revolving line of credit because you aren’t sure exactly how much money you need to borrow.
• Personal loan: If you don’t have much equity in your home, consider a personal loan instead. Just be aware that you’ll likely pay a higher interest rate.
• Credit card: You can always use a credit card to cover a major expense. But this option is only ideal if you can afford to pay it off quickly.
• Retirement accounts: You’re allowed to withdraw money penalty-free from retirement accounts before age 59½ if you have a qualifying expense, like medical bills or college tuition.

Frequently asked questions

Can I sell my house if I have a home equity loan?

Yes, you can sell your house if you have a home equity loan, but the loan must be paid off before the transaction can close. You’ll also need to pay off your remaining mortgage balance. Many homeowners use the money from the home sale to pay off their loans.

How much can I borrow with a home equity loan?

Most lenders allow homeowners to borrow up to 80% of their home’s equity, minus the remaining mortgage balance. This is called the loan-to-value (LTV) ratio. You can calculate your LTV by multiplying your home's value by 80% and subtracting your mortgage balance.

Are there closing costs for a home equity loan?

Home equity loans do have closing costs, which usually range from 2% to 5% of the loan amount. So, for example, if you get approved for a $100,000 home equity loan, you can expect to pay anywhere from $2,000 to $5,000 in out of pocket closing costs.

How long does it take to get a home equity loan?

On average, it takes roughly two to six weeks to get a home equity loan, but the exact time can vary. Before the loan can close, the lender must process your application, appraise the home, and underwrite the loan.