- A home equity loan allows you to access some or all of the equity that you've built in your home.
- These installment loans carry many benefits, but they also have some drawbacks that may cause you to think twice.
- Home equity loans and home equity lines of credit both use your equity as collateral, but these forms of debt function very differently.
A home equity loan is a loan that allows homeowners to access some or all of the equity that they've accumulated in their home, or the difference between their home's value and their existing mortgage balance. Because it's an addition to a traditional mortgage loan, it's also known as a second mortgage.
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How does a home equity loan work?
A home equity loan provides a lump-sum disbursement of the amount you want to borrow, which you repay in equal monthly installments. Here's a quick summary of the different features of home equity loans:
Repayment terms: In most cases, repayment terms range from five to 20 years, but some lenders may go as long as 30 years.
Loan amounts: That depends on how much equity you have in your home and the lender. Many lenders only allow you to borrow up to a combined loan-to-value ratio (CLTV) of 80%. This means that the sum of your first and second mortgage balances cannot exceed 80% of the value of your home. For example, if your home is worth $500,000 and you have a $350,000 mortgage balance, the most you can borrow with a home equity loan is $50,000. That said, some lenders offer higher CLTV limits that can be as high as 100%.[2-3]
Collateral: As with a mortgage loan, a home equity loan is secured by your home as collateral. As a result, home equity loans tend to offer relatively low interest rates, close to what you might qualify for with a standard mortgage loan.[4,5]
Loan uses: You can use home equity loan funds for just about anything you want, and because they offer relatively low interest rates, they can be more appealing than alternative options, such as credit cards and personal loans. Potential options include debt consolidation, home renovations, business startup expenses, medical bills, emergency savings, wedding costs and more.
Costs: While home equity loans offer low interest rates—generally fixed—they also come with closing costs, which are similar to the costs you paid when you took out your first mortgage. These costs can range from 2% to 5% of the loan amount. On a $50,000 loan, for instance, those costs can typically run you between $1,000 and $2,500. Some lenders will let you roll these costs into the loan, while others may require you to pay them up front.[4, 7]
Taxes: Historically, home equity loan interest had been tax-deductible, regardless of how you use the funds. But in 2017, the Tax Cuts and Jobs Act changed the tax code so that you can only deduct your interest if you use the loan funds to buy, build or substantially improve the home you're using as collateral for the loan. This provision remains in place until 2026—unless Congress chooses to extend it.
Example of a home equity loan
Let's go with the previous example and say that you have a $500,000 home and a $350,000 mortgage loan.
With a lender that maxes out at an 80% CLTV, you'd only be able to borrow $50,000. But let's say you find a lender that's willing to go up to a 90% CLTV. With this lender, you could borrow up to $100,000.
Let's say you go with that lender who gives you the following terms:
Closing costs: $3,000
Interest rate: 5%
Repayment term: 15 years
The lender also allows you to roll the closing costs into the loan, making your total loan amount $103,000. With a 15-year repayment period, your monthly payment would be $791, and over the life of the loan, you'd pay $42,343 in interest.
How to Get a Home Equity Loan in 5 Steps
How to Get a Home Equity Loan in 5 Steps
Processes and requirements can vary by lender, but there are some general guidelines you can follow.Find out more
Pros and cons of home equity loans
As with any financial product, there are both benefits and drawbacks to home equity loans, and it's crucial that you consider every aspect of how they work to determine if one is right for you.
In addition to weighing both the pros and cons, "homeowners should explore all options, plan for a change in their job status or an economic downturn, and then assess the viability of taking on additional debt and monthly payments," says Michael Gifford, co-founder and CEO of Splitero, a home equity investment firm.
- Low interest rates: Compared to personal loans, credit cards and many other financing options, home equity loans typically carry a lower interest rate.
- Long repayment terms: You can get up to 20 or even 30 years to pay back your loan, depending on the lender and how much you borrow.
- Fixed rates: Unlike home equity lines of credit, home equity loans typically charge fixed interest rates, which means that you don't have to worry about your interest rate or monthly payment changing over time.
- Flexible uses: Unlike with a first mortgage, you can use your “second mortgage” for just about anything you want.
- Potential tax benefit: If you use your loan funds to buy, build or substantially improve your home, you could deduct the interest you pay on your loan from your income every year.
- Collateral requirement: You're required to use your home as collateral for the loan, which means that if you can't pay it back, the lender could foreclose on your home and kick you out.
- Closing costs: Depending on the lender and how much you borrow, closing costs can get expensive fast, neutralizing some of the value you get from a lower interest rate.
- Loan limits: Depending on how much you want to borrow, you may be limited by how much equity you have in your home. This means it can be difficult to take advantage of a home equity loan unless you've been in the home for quite some time.
- Credit requirements: While the loan is secured by your home, you'll still typically need a credit score of 620 or above to get approved, and some lenders have higher minimums. Even if you meet the minimum requirement, though, the higher your credit score, the better your chances of securing a low interest rate.[10,11]
Home equity loan vs. home equity line of credit: What's the difference?
Another type of second mortgage option is a home equity line of credit (HELOC). Unlike a home equity loan, which is an installment loan, HELOCs are a revolving credit line, similar to a credit card, which means that you can take draws as needed and only pay interest on the amount you've borrowed. You can then pay back what you've borrowed and borrow it again.
HELOCs have two periods: a draw period and a repayment period.
During the draw period, which typically lasts up to 10 years, you can take draws and pay them back as you wish, but you technically only have to pay off the accrued interest each month.
Once the repayment period starts, which can go as long as 20 years, you can no longer take draws, and you'll have to pay back your existing balance over a fixed period. During this time, your interest rate remains variable, but some lenders may allow you to convert some or all of your balance to a fixed rate.
Here's a quick breakdown of the differences between home equity loans and lines of credit:
|Home equity loan||HELOC|
|Credit type||Installment loan||Revolving credit line|
|Disbursement||Lump sum||Draws as needed|
|Interest rate||Fixed||Variable, though sometimes with the option to convert to fixed|
|Payments||Fixed for the life of the loan||Typically interest-only dues during the draw period, then full payments during the repayment period|
|Tax benefits||Interest is deductible if you use loan funds to buy, build or substantially improve the home used as collateral||Interest is deductible if you use loan funds to buy, build or substantially improve the home used as collateral|
|Draw period term||None||Up to 10 years|
|Repayment period term||Up to 30 years||Up to 20 years|
If you're trying to decide between the two, a HELOC may be better if you simply want access to a line of credit without paying interest on the full amount or you have a need that requires multiple draws over an extended period rather than a one-time disbursement.