What Is a Home Equity Loan?
Bills Bottom Line
A home equity loan lets you borrow against the value you've built in your home. You get a lump sum, a fixed rate, and predictable monthly payments, typically at lower rates than those for a personal loan or a credit card. Lenders can offer those rates because your home secures the loan.
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You own a home. And somewhere along the way, you heard you could borrow against it. Now you're wondering what that means.
Home equity is simpler than it sounds. It's the difference between what your home is worth today and what you still owe on your mortgage. That gap is yours.
That gap is worth understanding.
What is a home equity loan?
Home equity loan definition
A home equity loan is a fixed-rate, lump-sum loan secured by your home, repaid in equal monthly payments over a set term.
That definition is accurate. But it doesn’t quite tell you what it feels like to take one out. Here's what each part means.
A loan secured by your home
When you take out a home equity loan, your home serves as collateral. That's what makes it different from a personal loan or a credit card. Because the lender has your home as backing, it's taking on less risk and will typically offer lower interest rates. But the trade-off is real. If you can't repay the loan, the lender could foreclose.
You borrow against your equity
Equity is the difference between what your home is worth today and what you still owe on your mortgage. The more you have built up, the more you may be eligible to borrow. But lenders look at your total mortgage debt against the home's value, including the new loan you want to take out. That's your combined loan-to-value ratio, or CLTV, and it determines how much you can borrow.
Here is how that works with a real example.
How much can you borrow?
An example based on an 80% lender limit:
| Amount | |
|---|---|
| Home value: | $300,000 |
| Lender limit: 80% | $240,000 |
| Minus what you owe: | $240,000 |
| You may be able to borrow: Up to... | $40,000 |
You receive the money as a lump sum
At closing, you receive the loan amount in one payment, minus any fees and closing costs. There's no draw period or revolving credit like you see with a home equity line of credit (HELOC). You get the money once and repayment begins.
The rate and payments are fixed
The interest rate stays the same for the life of the loan, and so does your monthly payment. Terms typically range from five to 30 years. What you sign up for is what you pay, start to finish.
Know what the loan actually costs
The interest rate is not the whole story. The APR (annual percentage rate) includes the rate plus fees. When you are comparing loans, that is the number to look at. The lower the APR, the less you'll pay to borrow the money.
Learn more about home equity loans
Here are some other key things to know about home equity loans.
What can you use a home equity loan for?
You can use a home equity loan for debt consolidation, home improvements, large one-off expenses, or just about anything else you can think of. If you have any questions about whether you can use a home equity loan for a specific purpose, ask your lender.
What are the risks of a home equity loan?
The main risk of a home equity loan is losing your home if you don't keep up with the payments. Also, if you opt for a home equity loan with low monthly payments, you could pay more in interest over the lifetime of the loan.
What do you need to qualify for a home equity loan, and how much can you borrow?
Home equity loan requirements vary by lender, but most typically look at your credit score, your debt-to-income ratio, your income, and the appraised value of your home when deciding whether to approve you.
These factors influence how much you can borrow. But generally, you cannot borrow more than 80% of the equity you have in your home.
HEL vs. HELOC: What's the difference?
Home equity loans and HELOCs are both ways to borrow against the equity in your home. A home equity loan has fixed monthly payments and gives you a lump-sum payout whereas a HELOC gives you a line of credit that you can spend, pay back, and spend again during the draw period. After that, you enter the repayment period, and you cannot borrow any more. HELOCs typically have variable interest rates, which means less predictable payments.
Is home equity loan interest tax-deductible?
Home equity loan interest can be tax-deductible, but it depends on how you use the money, how much you borrow, and how you file your taxes. Generally, you must use the funds to improve the value of your home and itemize deductions on your tax return to deduct your home equity loan interest.
Can you cancel a home equity loan after signing?
You're legally allowed to cancel a home equity loan within three days after signing for any reason if you're using your primary residence as collateral.
Why a home equity loan is called a second mortgage
If you already have a mortgage, a home equity loan sits behind it in priority. Two loans are now secured by the same property. That is what “second mortgage” means—not two homes, just two loans on the same one.
The second position matters. If your home is ever sold, the first mortgage gets paid off before the second. That added risk to the lender is why home equity loans often carry higher rates than first mortgages.
Bills Action Plan
- Calculate your equity. Subtract what you owe on your mortgage from your home’s current market value. That is your starting point.
- Understand what you could qualify for. Lenders typically look for a credit score of 620 or higher and consider your debt-to-income ratio. Specific requirements vary by lender.
- Compare your options. A home equity loan is only one way to access your equity.
Key Terms
Home equity: The difference between your home’s current market value and the amount you still owe on your mortgage(s).
Lump sum: Receiving the full loan amount in a single payment at closing, rather than drawing funds over time.
Fixed rate: An interest rate that stays the same for the life of the loan, meaning your monthly payment does not change.
Collateral: The asset securing the loan. For a home equity loan, your home is the collateral.
Second mortgage: A loan secured by your home while your original mortgage is still active. Home equity loans are a common type of second mortgage.
APR (annual percentage rate): The cost of the loan expressed as a yearly rate, including the interest rate and fees. Always compare APRs, not just interest rates.
How does having a home equity loan affect refinancing?
If you have a home equity loan, you may wrap the home equity balance into the new loan or refinance the first mortgage and leave the home equity loan alone.
Wrapping the home equity balance into a new loan can save you interest. However, many lenders consider a refinance that pays off a home equity loan balance to be a cash-out refinance. And they charge higher fees for cash-out refinancing. So you’d have to calculate whether the interest savings exceed the additional cost, and for most borrowers, that answer is no.
When you refinance the first mortgage and keep the second mortgage, you’ll have to “resubordinate” the second mortgage to the new first mortgage. That’s because when you pay off the old first mortgage, the second mortgage automatically moves into the first position. No refinance lender will take the second position, so the second mortgage must be resubordinated to the new mortgage.
That’s not normally a problem, but some lenders refuse to resubordinate loans. You should look at your loan documents before taking out a home equity loan in case the lender does not resubordinate. If your home equity lender refuses to resubordinate, you may have to refinance that loan with a willing lender before refinancing your first mortgage.
What are the best home equity loans?
The best home equity loan for you depends on your credit rating, amount of equity, home value, and desired loan amount. Mortgage lenders often have a preferred tier of borrowers they target, and their terms won’t be competitive for borrowers they’re not seeking. That’s why it’s a best practice to compare offers from several home equity lenders before applying.
Home Equity Loan or Personal Loan?
If the drawbacks listed above concern you, consider a personal loan. Personal loans are usually unsecured and have fixed interest rates. The lender can’t take your home if you default on your loan. And you can choose from several terms when you take a personal loan – mostly between one and 12 years, so you can pay your balance off faster and potentially save on interest. In addition, some personal loan providers offer the most highly-qualified applicants rates that approach those of home equity products. So, a personal loan might be a better option than home equity for a few reasons.
On the other hand, if you need a large-ish sum for a good reason and want a low interest rate, home equity financing is likely to be your best option.
Are home equity loan interest rates fixed or variable?
Home equity loans are usually installment loans with fixed interest rates and unchanging payments. Most HELOCs have variable interest rates.
How long does a home equity loan take to close?
The standard answer is two-to-six weeks. However, if your credit score is very high and your loan-to-value is low, you can get preapproved very quickly, and your lender may allow a “desk appraisal,” which can save a lot of time. If your LTV is high, you’ll have to wait for an appraiser to see your home and complete a report. That’s often the bottleneck in mortgage processing.