Home Equity Loans 101: What They Are, How They’re Used and What You Need To Get One

couple discussing home equity loan

When it comes to loans, it can be hard to decide which option is right for you. For homeowners hoping to consolidate debt or pay major expenses, home equity loans are a popular option.

In fact, record-high home values, low interest rates and fears of rate hikes drove Americans to withdraw $49.6 billion in equity from their homes during just the first three months of 2021 — about 80% more than the same time last year, The Wall Street Journal reported.

Although the time seems ripe to take out a home equity loan, it’s not your only option for drawing against your equity, and it might not be the best one. Keep reading to find out what a home equity loan is, how it works and how it differs from a home equity line of credit.

What Is a Home Equity Loan?

A home equity loan is a type of loan that lets you borrow against the equity in your home — equity being the portion of your home’s value that you own outright, after you subtract any current mortgage or equity loan balances. How much of that equity you can borrow depends on the lender, but most lenders cap the amount at 85% to 90% of your home’s value, inclusive of all loans. An online home equity loan calculator can help you with the math.

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The minimum you can borrow depends on the lender. Discover’s minimum is $35,000, for example, whereas U.S. Bank’s is $15,000.

Because your home serves as security, or collateral, for a home equity loan, the loan is considered a mortgage. That means the bank can foreclose on your home in the event you default on the loan. If you already have a mortgage loan, which is usually the case for home equity borrowers, the home equity loan would be a second mortgage. Otherwise, the loan would be considered a first mortgage.

Home equity loans usually have a fixed rate that keeps your payment consistent over the entire life of the loan. Loan terms vary by lender and range anywhere from five to 30 years. A longer loan term keeps your payments low but costs you more in interest in the long run.

Home Equity Loan Requirements

Just like with any other loan you might apply for, you’ll have to qualify for a home equity loan. Here’s what lenders look for:

  • Equity: Lenders usually allow a total loan-to-value ratio of 85%-90%.
  • Credit score: A 620 minimum credit score is typical to qualify, but some loan terms and amounts might require a higher score.
  • Credit history: Lenders want to see a varied credit history with no recent late payments.
  • Work history: You’ll need to document two years of steady employment if you need your wages — as opposed to retirement or other income — to qualify for the loan.
  • Income: You’ll need to document your income by submitting W2s and recent pay stubs — or 1099s and tax returns, if you’re self-employed — plus statements showing investment and other income you want the lender to consider.
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Good To Know

Some banks, including major ones like Wells Fargo and Bank of America, have temporarily discontinued offering home equity loans due to the effects of the pandemic on the economy. Home equity loans, which are usually second mortgages, are riskier to banks because the bank is less likely than the primary mortgage lender to recover its losses if a borrower defaults.

Reasons People Take Out Home Equity Loans

Home equity loans are usually large loans, and the process for getting one is similar to the one you followed when you took out your purchase loan. Therefore, they’re best reserved for major, one-time expenses you can’t cover otherwise — or for debt that will cost you more to carry over time than a home equity loan will. Here are some common reasons homeowners use them:

Home Improvements

Extensive remodeling or large home repairs can be costly, so many people opt to take out a home equity loan to cover these expenses. Increasing the value of your home isn’t the only good reason to make improvements, but if it’s an important one for you, know that the resale value of most home improvements is less than their costs. You’ll only recoup about 60% of the cost of an average bathroom remodel, for example, according to Remodeling magazine’s 2021 Cost vs. Value Report.

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Consolidate Debt

Because the interest rate on a home equity loan is much lower than for credit cards and other loans, many people use the home equity loan to consolidate and pay off previous debts since it can save them money on interest costs. This can, in turn, help you pay off your debts much sooner.

Pay for Education

It’s no secret that education is expensive, especially higher education. The average price of tuition and fees for a student to attend a four-year university for one year ranges from $10,338 for an in-state public school to more than $38,185 for a private school, according to U.S. News & World Report. Multiply that figure by four years, and total education costs can easily reach over $100,000 for one student.

The interest on a home equity loan isn’t always less than the interest on an education loan. Discover, for example, quotes annual percentage rates ranging from 4.15% to 11.99% for second mortgage. In comparison, borrowers pay 4.45% or 7%, respectively, for federal Stafford and Plus loans. But home equity loans have a benefit those loans don’t — much higher limits, assuming you have sufficient equity.

Medical Expenses

A home equity loan can keep you from having to sacrifice your health because of the high cost of treating a catastrophic illness or injury. Just be aware that you’ll need a steady income to qualify for the loan, and if your illness or recovery renders you unable to continue making your payments, you could lose your home.

Pros of Home Equity Loans

If you’re considering a home equity loan, weigh the pros and cons against other options to decide if it’s the best way to borrow for your situation. Here are some of the perks of home equity loans:

Home Equity Loan Interest Rates Are Usually Low

Because the risk for a lender is lower — since repayment of the loan is secured through the collateral of your home — interest rates are typically lower than those of unsecured loans.

Fixed Payments

Unlike credit cards, which usually come with variable APRs, home equity loans usually have fixed interest rates, which translate to fixed monthly payments.

May Be Tax-Deductible

Your home equity loan is tax-deductible as long as you use it to buy, build or substantially improve the home you borrow against. But you might have deductions other than interest on things you use the loan for — eligible education or medical expenses, for example.

Cons of Home Equity Loans

Although home equity loans might seem like a sweet deal if you’re in need of a large sum of money, there are a few things to watch out for:

Costs and Fees

Home equity loans typically have closing costs that total 2% to 5% of the loan amount. The fees might include application and origination fees, title fees, document preparation and filing, and the appraisal your lender will order to verify your property’s market value.

It Could Cost You Your Home

A home equity loan is secured by the home you borrow against. Defaulting on the loan could result in foreclosure.

It Doesn’t Change Spending Habits

If you use a home equity loan to pay off high-interest credit card debt, you could face a double whammy later if you run up your card balances again. To avoid doubling your debt, evaluate your budget and make a plan to spend within your means.

Home Equity Loan vs. Home Equity Line of Credit

A home equity line of credit differs from a home equity loan in that it operates more like a credit card. Rather than receive the entire loan amount upfront, draw the funds as you need them, up to the amount of your credit limit, during an initial draw period that generally lasts 10 years. Once that draw period ends, you can’t borrow against your line of credit anymore. You then have 10 to 20 years, depending on your loan term, to repay the loan.

Home Equity Loan HELOC
Fixed interest rate Variable interest rate
Make payments on the entire loan amount Make payments on the amount you actually borrow
Receive large sum of money at once Borrow as much as you need at any time, up to your credit limit
Loan term of 5 to 30 years Draw period, usually 10 years, followed by a repayment period of 10-20 years

Alternatives To Home Equity Loans and Lines of Credit

If you currently have a mortgage loan on your home, a cash-out refinance might be a better option than a home equity loan. With a cash-out refi, you take out a new first mortgage for more than you need to pay off your current mortgage and take the excess amount as a lump-sum cash payment. You’ll need sufficient equity, just like with a home equity loan, but you’ll likely pay a lower rate because a cash-out refinance is always considered a first mortgage and thus less risky for the lender.

Taylor Bell contributed to the reporting for this article.

About the Author

Daria Uhlig is a personal finance, real estate and travel writer and editor with over 25 years of editorial experience. Her work has been featured on The Motley Fool, MSN, AOL, Yahoo! Finance, CNBC and USA Today. Daria studied journalism at the County College of Morris and earned a degree in communications at Centenary University, both in New Jersey.

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