What is a home equity loan, and how does it work?
You can get a loan or line of credit with your home as collateral
When you need funds to pay for a home renovation, consolidate debt or pay for an emergency, consider tapping into your home’s equity. A home equity loan allows you to borrow against the value of your home and access a lump sum of money to use for a variety of purposes.
A home equity loan typically comes with lower interest rates and higher borrowing limits compared to different financing options, like credit cards and personal loans.
Key insights
- Your borrowing limit is determined by the current market value of your home and how much you owe on it.
- Home equity loans are repaid in regular monthly installments over a fixed term, usually ranging from five to 30 years.
- The collateral for home equity loans is the property itself, which means that if you fail to repay the loan, the lender has the right to foreclose on your home.
What is a home equity loan?
A home equity loan is a loan in which borrowers use their house as collateral. You can get a home equity loan before or after you pay off your first mortgage, which is why it’s sometimes called a “second mortgage.” Home equity loans are conforming loans, so the minimum and maximum loan amounts are determined by the amount of equity you have in your property as well as federal regulations.
You can take out a large sum of cash upfront and repay the home equity loan over time with fixed monthly payments. Or, you can get approved for a home equity line of credit, or HELOC, which gives you access to the maximum amount available to borrow if needed. Either way, if you’re unable to keep up with rising interest rates or if the value of your home suddenly drops, you’ll be at risk of foreclosure.
The average person takes five to 15 years to pay off a home equity loan
How does a home equity loan work?
When people refer to their “home equity,” they are talking about the difference between the market value of their house and how much they owe on it. A home equity loan is especially advantageous if your property values have gone up since you purchased your home.
“One thing to keep in mind is the fact that you usually can only borrow up to 85% of your home's value, spread across your mortgage and the home equity loan,” said Maureen McDermut, a real estate agent for Sotheby's International Realty in Santa Barbara. “So let's say your home is currently worth $700,000, then you can only have $595,000 in loans on it between your mortgage and a home equity loan.”
» MORE: Home equity loan requirements
Home equity loan vs. line of credit
You should think of a home equity loan as a second mortgage, and there are two main types: fixed-rate home equity loans and HELOCs. Both home equity loans and HELOCs use your house as collateral, but they have some very important differences.
A home equity loan is best for:
- A one-time lump sum
- Fixed-rate repayment terms
- When you know exactly how much you need to borrow, like a fixed $30,000 bathroom remodel
A HELOC is more like a credit card and is best for:
- Borrowing up to a set amount over a period of time, usually 10 years
- Paying interest on only the amount you draw
- Variable or adjustable interest rates
- When your expenses can ebb and flow, such as a kitchen remodel that can range between $90,000 and $150,000
| Consideration | Home equity loan | Home equity line of credit |
|---|---|---|
| Access to funds | Lump sum | Draw period of 5–10 years |
| House as collateral | ✔ | ✔ |
| Adjustable interest rates | X | ✔ |
| Flexible payment options | ✔ | X |
Most borrowers find that HELOCs are easier to get than home equity loans, but their rates are variable. Keep in mind that rates can change all the time, so even if you are able to get an adjustable interest rate on a home equity loan, it may not be ideal if rates are currently low and are expected to rise.
Pros and cons of a home equity loan
Using your home equity for financing can be beneficial if you have a specific goal in mind, such as home improvements, debt consolidation or funding a major expense. But remember, it is not free money. You will need to repay what you borrow with interest, and risks are involved when using your home as collateral for a loan.
Consider these pros and cons before deciding if a home equity loan is the right financing choice for you.
Pros
- Access to more funds: With a home equity loan, you can typically borrow a significant amount of money based on the equity you have in your home.
- Lower interest rates: Home equity loans often offer lower interest rates in comparison to other forms of borrowing, such as personal loans or credit cards.
- Doesn’t affect your current mortgage rate: If you have a low interest rate on your current mortgage, a home equity loan doesn’t affect that rate like a cash-out refinance would.
Cons
- Costly closing fees: Similar to when you initially purchased your home, a home equity loan may come with closing costs and fees, including appraisal fees and origination fees.
- Additional debt burden: You will need to repay your home equity loan with interest, which will add an additional monthly payment to your budget.
- Risk of losing your home: If you are unable to make the loan payments, you could face the risk of foreclosure and losing your home.
Home equity loan alternatives
If you decide that a home equity loan is not the right option for your financing needs, these alternatives can be used instead.
- Personal loan: With a personal loan, lenders determine the amount you can borrow based on your credit history and current income. The lender sets your interest rate based on creditworthiness and the market, and you repay the loan as fixed monthly payments.
- Credit cards: Similar to a HELOC, you can use a credit card as a line of credit. A credit card is a good option if you need funds quickly, but they are more expensive in the long term, with annual percentage rates (APRs) as high as 20%.
- Cash-out refinance: Cash-out refinancing allows you to access your home equity by replacing your current mortgage with a new one. Refinancing your home requires meeting lender requirements and can get you a better (or worse) interest rate than you currently have.
- Home improvement loan: Home improvement loans are a type of personal loan that can be used for your home remodeling projects.
- Federal programs: The Federal Housing Administration offers programs like Title I loans and Energy Efficient Mortgages that can help you secure funds to pay for home improvements and renovations.
FAQ
How does a home equity loan affect my home ownership?
When you take out a home equity loan, it creates a lien on your property. This means that if you sell your home, the loan must be paid off from the proceeds of the sale. Until the loan is fully repaid, it can limit your options for selling or refinancing your home.
Is a home equity loan tax deductible?
As of now, no. In the past, interest paid on home equity loans was tax deductible if the funds were used for remodeling or renovation purposes. Home equity loan interest might be tax deductible again after 2025.
Bottom line
A home equity loan is a good idea if you have equity built up in your home and need financing. As long as you have a clear purpose for the funds and a repayment plan in place, you can benefit from this loan without the risk of not having enough money to repay your loan.
Article sources
- IRS, " Is interest on a home equity line of credit deductible as a second mortgage? " Accessed June 17, 2023.
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