What Is a Home Equity Loan?

What is a home equity loan? It’s a way to exchange some of your home value for cash without selling your property. Home equity loans are unique products with special rules, and you should understand them before borrowing.

What Is Home Equity?

Home equity is the portion of your property value that you (and not your mortgage lender) own. You get home equity when you make a down payment on your property or pay down your mortgage and when your property value increases. Home equity is a valuable asset you can use to enhance your financial security. According to Harvard University’s Joint Center for Housing Studies, “At last measure in 2019, the median wealth for homeowners was $254,900 – more than 40 times the $6,270 median for renters.”

You lose home equity when you borrow against it or when your property value decreases. Because home equity is so valuable, most personal finance experts recommend tapping it very carefully.

How Do You Calculate Home Equity?

The short answer is that you subtract the total of all loans secured by your home from its current value. If your property is worth $400,000 and you have a $200,000 mortgage and a $50,000 home equity loan against it, your home equity is $150,000. 

• $200,000 + $50,000 = $250,000 total loans
• $400,000 - $250,000 = $150,000 home equity

However, mortgage lenders calculate home equity differently – usually as a percentage of your property value. For the example above, your lender might determine home equity this way:

• 1 - (loans/home value)
• 1 - ($250,000 / $400,000)
• 1 - (.625) = .375 = 37.5%

Your home equity is 37.5% of your property value, and your loan balances total 62.5%. Your lender would say that your loan-to-value ratio is 62.5%. Loan-to-value, or LTV, is a highly-important calculation and term to know if you’re considering a home equity loan.

What’s the Difference Between a Home Equity Loan and a Mortgage?

The loan you used to buy your house and a home equity loan are both mortgages. “Mortgage” refers to any loan secured by your home. If your home is collateral for a loan, that loan is a mortgage. If you fail to repay any mortgage, the lender can foreclose, take your home, and sell it to recoup the loan balance. 

The biggest home equity loan vs. mortgage difference is timing. Lenders often call the original home loan you use to purchase your home a “first mortgage” and a home equity loan a “second mortgage.” The first mortgage takes “first position,” which means if there is a foreclosure, the first mortgage lender gets repaid from the proceeds. The second lender will only receive money if enough is left after the first lender takes its cut.

This brings us to the next difference between first and second mortgages…

Why Are Home Equity Loan Interest Rates Higher Than First Mortgage Rates?

If you compare rates offered to the same borrower for the same property, interest rates for home equity loans are higher than first mortgages. The reason for that comes down to the position of the loan.

The lender in the first position takes on less risk than the lender in the second position. There is every chance that the first lender will get its money back if a foreclosure sale happens. But the home equity lender takes on more risk. Sometimes a lot more risk. Because of this, it has to charge higher interest rates. 

How Does a Home Equity Loan Work?

How does a home equity loan vs. mortgage loan work? Actually, the home equity loan is a mortgage. A mortgage is a loan secured by real estate. Your home is the collateral when you take out a home equity loan. The lender can foreclose and take your home if you don’t make your home equity loan payments.

Home equity loans are installment loans, and they usually have fixed interest rates and payments over their entire terms. The lender calculates your monthly payment to zero your balance at the end of the loan term. 

Home equity loans work a lot like fixed-rate personal loans. You get a lump sum at closing, and you pay the loan back in equal monthly installments. The major difference between home equity loans and personal loans is the collateral. Most personal loans are unsecured. They are riskier to lenders, and so their interest rates are higher. But they are safer for borrowers because you can’t lose your home if you default on a personal loan.

How Much Can You Borrow With a Home Equity Loan?

You can’t borrow against all of your home value. Following the Great Recession, mortgage lending guidelines became much more restrictive, and most lenders limit home equity borrowing to 80%, 85%, or 90% of home equity. 

Lenders determine maximum loan amounts by calculating your combined loan-to-value, or CLTV. The CLTV is the percentage of home value securing all mortgages against the property. For instance, if your home is worth $500,000, and you owe $350,000 on your first mortgage and have a $50,000 home equity loan balance, your CLTV equals ($350,000 + $50,000) / $500,000. That’s $400,000 / $500,000, which equals .8 or 80%.

Let’s say that your lender will allow a CLTV of 85% for home equity financing. How much might you borrow if your property value is $250,000 and you owe $175,000? Here’s the calculation:

• $250,000 * .85 = $212,500 
• $212,500 - $175,000 = $37,500

If you qualify, your maximum loan amount at 85% CLTV is $37,500

What Are Good Uses for a Home Equity Loan?

One day, your home equity could be the source of a comfortable, secure retirement. That’s why you should use it wisely if you borrow.

Good uses for home equity financing include education, a business, an investment, consolidating high-interest bills, a down payment on a home, or home improvements. Of course, that only works if the education increases your earning power, the business succeeds, the investment pays off, the debt consolidation saves money, or the home improvement adds value. It’s essential to evaluate the merits of the project before pulling the trigger on a home equity loan.

What are bad uses for a home equity loan? Financial planners don’t like to see you take out a long-term loan (home equity loans can have terms up to 30 years) for a short-term purchase. Less-great uses for home equity financing can include travel, weddings, cars, retail therapy, and debt consolidation if your spending is uncontrolled. 

That said, short-term purchases can still be good uses for home equity if you pay off your loan quickly. Most home equity loans have no penalty for accelerating repayment; check the loan documents if this is a consideration.

What Is the Difference Between a Home Equity Loan and a HELOC?

Home equity loans and home equity lines of credit, or HELOCs, are both mortgages secured by your home equity. But the home equity loan delivers a lump sum, which you pay off in monthly installments over time. A HELOC, on the other hand, is more open-ended – like a credit card. You can borrow as little or as much as you like, up to your credit limit. Interest rates are usually variable, and your payment depends on the interest rate and the amount of credit used. 

What Credit Score Is Needed for a Home Equity Loan?

The minimum credit score needed for a home equity loan depends on the LTV and the lender. Some home equity lenders specialize in home equity loans for bad credit but only for low LTVs – 70% or less. Most, however, set their minimum credit scores at 680. 

The exception is the “purchase money” second mortgage. Purchase money second mortgages are used to cover some of the down payment on a property. If you have saved 5% of your home’s purchase price, you can put 5% down and get a 95% first mortgage. And you’ll have to buy mortgage insurance, which can be expensive, So you might choose to get an 80% first mortgage and a 15% purchase money second mortgage instead. Some purchase money second mortgage lenders accept credit scores as low as 620. 

What Are Home Equity Loan Advantages?

The main advantage of home equity financing is that it’s usually the cheapest money around. When an asset like home equity secures a loan, lenders can offer lower interest rates. 

Another possible advantage is favorable tax treatment. For interest to be tax-deductible, home equity loan amounts must fall within designated limits and be used for approved purposes. In addition, you need to itemize deductions to deduct home equity loan interest on a Schedule A. Check with a tax pro before borrowing if this is a consideration.

Finally, home equity loans offer smaller payments than other financing because of their low interest rates and extended repayment terms. That can give you some breathing room if you’re strapped by bills.

What Are Home Equity Loan Drawbacks?

The main home equity drawback is the same characteristic that makes home equity financing cheap – the lender can foreclose and take your home if you fail to make your payments. 

Another sneakier drawback is the long term which keeps your payment low. Taking decades to repay a balance will cost you more in interest than a shorter-term loan, even if that loan carries a higher rate. It costs more in interest to finance debt at 5% over 15 years than it does at 12% for five years. 

Home Equity Loan vs. Cash-Out Refinance: Which Is Better?

Choosing between a home equity loan and a cash-out refinance is easy because it’s only about the numbers. There are some factors in play:

• Cash-out refinancing costs more than standard rate-and-term refinancing.
• Mortgage insurance is a factor if your refinance exceeds 80% of the home value.
• Home equity loan processing can be faster than a cash-out refinance. 

So, you need to compare the lifetime costs of these three options:

• Keeping your existing mortgage and adding a home equity loan
• Refinancing your existing mortgage and adding a home equity loan
• Replacing your existing mortgage with a cash-out refinance. 

Note that even if you can improve on the terms of your existing mortgage, it may still be cheaper to do a rate-and-term refinance and add a home equity loan than to take out a cash-out refi. Because cash-out refinance fees apply to the entire loan balance, not just the cash-out, it may make sense only if your existing mortgage balance is low and you want a lot of cash out.