How Does a Home Equity Loan Work?

You've built equity in your home one payment at a time. Now, you want to use that equity. You’re pretty sure you can use it to get a loan—but you’re less sure how that actually works. 

How do you get from I want to use my equity to cash in your bank account?

A home equity loan is a second mortgage. You borrow a fixed amount and receive it as a lump sum at closing. You repay it in regular monthly installments at a fixed interest rate, typically over 5 to 30 years. Your home secures the loan, so the lender could foreclose if you stop making payments.

Ready to learn more? Let’s explore how the numbers work, what the process looks like, and what it costs, so you can make confident decisions about how to use your home equity.

What is home equity, and how does it work?

Home equity is the difference between your home's current market value and the total amount you owe on any loans secured by it—your mortgage, plus any other liens like a HELOC or existing home equity loan. That's it.

Here's what that looks like: If your home is worth $400,000 and you owe $250,000 on your mortgage with no other home loans, your equity is $150,000.

$400,000 - $250,000 = $150,000

Your home equity could grow in two ways: 

• Paying down your loan. Every mortgage payment you make reduces your loan balance, adding to your equity.
• Increasing property values. If the housing market pushes your home's appraised value up, your equity rises with it. The reverse is also true. If home values fall, your equity shrinks. That's worth knowing before you borrow against it.

You can tap into your home’s equity by using it as collateral for a loan. Collateral is security, or something of value you own that backs up a loan. Home equity loans are secured by your home.

For a deeper dive into the details of a home equity loan, see our guide: What is a home equity loan?

How much can you borrow with a home equity loan?

Not all of your equity is available to borrow against. Lenders use a calculation called CLTV to help set your borrowing limit.

In plain English, CLTV stands for combined loan-to-value ratio. It's all the loans on your property added together, divided by your home's market value. Lenders use it to make sure you keep a cushion of equity even after borrowing.

Many lenders limit your total borrowing to 80% of the equity in your home. Some allow a CLTV up to 85% or 90%, depending on your credit score and financial profile, but terms vary by lender.

Here's what that looks like with real numbers. Say your home is worth $400,000 and you owe $250,000. If your lender allows an 80% CLTV, the maximum total debt against your home is $340,000. Since you already owe $250,000, the most you could borrow is $90,000.

This is the calculation:

$400,000 x 0.85 = $320,000

$320,000 - $250,000 = $70,000

Lenders also look at two more things when determining how much they'll lend:

• Your credit score. Most home equity loan lenders prefer a credit score of 620 or higher. A stronger score may give you access to more equity or better rates.
• Your debt-to-income ratio (DTI). That's the percentage of your gross monthly income going toward debt payments, including your mortgage. Most lenders prefer a DTI at or below 36%, though some may approve borrowers with a DTI up to 50%.

Lenders require some form of appraisal to confirm your home's current market value. They may request an in-person appraisal, but many lenders now use digital valuation for a home equity loan.

What are the costs of a home equity loan?

The interest rate gets most of the attention—and interest will be a big part of the cost. However, closing costs are real too, and worth comparing before you apply.

Home equity loans carry a fixed interest rate, set at closing, that does not change. Rates for home equity loans tend to be higher than rates for purchase mortgages, but lower than rates of unsecured loans like personal loans or credit cards.

Closing costs on a home equity loan typically range from 2% to 6% of the loan amount. The exact figure varies by lender, so you can shop around to look for lower fees.

Those costs may include: 

• Origination fee
• Appraisal fee
• Title search
• Recording fees

Closing costs get their name because you pay them when you close the loan. With a refinance or home equity loan, you may be able to wrap your closing costs into the loan. 

It’s important to consider closing costs when looking at loan terms. Some lenders offer reduced or no upfront closing costs, but these often come with a higher interest rate. Compare the total cost of all options over the life of the loan before deciding.

A note on taxes. Interest on a home equity loan may be tax deductible. It qualifies only if the funds are used to buy, build, or substantially improve the home securing the loan. Using the funds for debt consolidation or personal expenses generally does not qualify. Consult a tax advisor for your specific situation.

How does a home equity loan work, step by step?

The home equity loan process moves in five stages:

• Step 1: Apply. Submit an application with income documentation, your current mortgage statement, and consent for a credit check. The lender checks your financials, credit history, and home value.
• Step 2: Appraisal. The lender orders a valuation to confirm your home's current market value. This determines how much equity you have and how much you may be able to borrow.
• Step 3: Underwriting. The lender reviews your full file: credit score, DTI, CLTV, and income documents. This is where approval is formally decided.
• Step 4: Closing. If approved, you sign the loan documents and pay closing costs. After closing, your lender will confirm when and how you'll get your money. 
• Step 5: Repayment. You make the same fixed payment every month for the full loan term. Each payment covers both principal (the amount you borrowed) and interest. In the early months, most of each payment goes toward interest. Over time, more goes toward the principal. The payment amount doesn’t change over the life of the loan.

One important federal right to know: You have three business days after signing to cancel a home equity loan on your primary residence. No penalty, no explanation needed. Business days include Saturdays, but not Sundays or federal holidays.

What happens to a home equity loan when you sell? 

Generally, if you sell your home, the outstanding home equity loan balance is paid off at closing from the sale proceeds. The money left over after all mortgages and seller's closing costs have been paid goes to you.

If the sale price doesn’t cover all of your home loans, you’ll likely need to make up the difference for the sale to go through. This is one reason lenders require you to retain meaningful equity in the home.

When does a home equity loan make sense?

A home equity loan fits best when you have a specific, fixed expense and want a predictable payment.

• Good fits: Large home improvement projects that require a lump sum, like an addition or extensive renovation. Big ticket purchases or the down payment on a vacation home. Debt consolidation could make sense if you're paying off high-interest debt and the home equity loan rate is meaningfully lower.
• Less good fits: Ongoing or unpredictable expenses like college tuition or home improvements that take place in stages, or to provide emergency cash for a new business. For those, a home equity line of credit (HELOC) may give you more flexibility.

The honest caution: Your home is the collateral for a home equity loan. If payments become difficult, the consequences are severe. Not just a credit hit—your lender could foreclose.

That's not a reason to avoid home equity loans. It's a reason to go in with your eyes open, however, and to make sure you have a solid repayment plan before you borrow.

Bills Action Plan

1. Calculate your equity today. Subtract your current mortgage balance from your home's estimated market value. A recent Zillow or Redfin estimate gives you a starting point. Your lender will verify your home’s value when you apply.
2. Check your credit score and DTI. Most home equity loan lenders prefer a credit score of 620 or higher and a DTI at or below 36%, though some may allow up to 50%. Pull your free credit report at AnnualCreditReport.com.
3. Get quotes from at least two lenders. Compare interest rates, closing costs, and loan terms side by side. Ask each lender for a Loan Estimate. It's a standard form so you're comparing identical numbers.

Key Terms

Home equity: The difference between your home's current market value and the total amount you owe on any loans secured by it. That includes your mortgage plus any other liens, such as a HELOC or an existing home equity loan. If your home is worth $400,000 and you owe $250,000 total, your home equity is $150,000.

Combined loan-to-value ratio (CLTV): All loans secured by your home divided by your home's value, expressed as a percentage. Lenders use this to determine how much you could borrow. A CLTV of 85% on a $400,000 home means total secured debt of $340,000.

Fixed interest rate: An interest rate that does not change over the life of the loan. Your monthly payment stays the same from the first payment to the last.

Lien: A legal claim a lender holds against your property as security for a loan. When you take out a mortgage, the lender places a lien on your home. A home equity loan adds a second lien. If you don't repay the loan, the lender can use the lien to force a sale of the property.

Second mortgage: Any loan secured by your home when a primary mortgage already exists. A home equity loan is usually a second mortgage. The second mortgage lender has a subordinate claim. If the home were sold to repay debts, the primary mortgage lender gets paid first.

Closing costs: Fees due at or before closing, typically including an origination fee, appraisal fee, title search, and recording fees.

Amortization: The process of paying off a loan through regular payments that cover both principal and interest. Early payments are mostly interest; later payments cover more principal. The payment amount stays the same throughout.