Home Equity

What Is a Home Equity Loan and How Does It Work? | NextAdvisor with TIME

· A home equity loan is a fixed-rate installment loan secured by your house. “A homeowner is able to borrow money from a bank, and the equity in 

If you own a home, it’s likely the biggest asset to your name — and its value has likely risen in the past year.

In the second quarter of 2022, homeowners across the nation saw the largest annual increase in “tappable equity” on record — an $11.5 trillion gain, according to a recent report by mortgage technology and data provider Black Knight. During this historic seller’s market, in which demand surged and inventory became scarce, the same report shows the average homeowner gained as much as 25% more equity year-over-year while still maintaining at least 20% in their homes.

That value can be put to work for you in the form of a home equity loan, which you can use for whatever purpose you want, from home improvements to paying for emergencies.

Here’s what you need to know about what is a home equity loan, how home equity loans work, and what you should consider before you get one.

What Is a Home Equity Loan?

A home equity loan is a fixed-rate installment loan secured by your house. “A homeowner is able to borrow money from a bank, and the equity in their home serves as collateral to the loan,” says Elliott Pepper, CPA, CFP, and co-founder of Northbrook Financial.

Commonly known as a second mortgage, home equity loans can offer homeowners a way to use their home equity to secure financing with competitive interest rates and relatively large loan amounts. Because of this, they’re a popular option to pay for home improvements or consolidate high-interest debt. However, they also carry a major risk: if you fall behind on payments, you could lose your home.

Home equity loans are related to but different from home equity lines of credit (HELOCs), which are variable-rate lines of credit secured by the borrower’s home equity.

How Does a Home Equity Loan Work?

A home equity loan lets you borrow against your home equity, which is calculated as the difference between your home’s market value and the remaining balance on your mortgage. You can usually borrow up to a certain percentage of your equity — the exact value depends on your lender’s requirements — and your house acts as collateral for the loan. This means that if you default, your lender could foreclose on your house.

A home equity loan has a set loan term, usually five to 30 years, and a fixed interest rate. You’ll receive the full loan amount (minus any origination fees) when you take out the loan, and pay it back, with interest, in fixed monthly payments over the course of the loan term.

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In general, home equity loans tend to have lower interest rates than personal loans and credit cards, as home equity loans are less risky for the lender because they’re secured debt. Your exact interest rate will be determined by factors such as your credit score, your loan term and loan amount, and your lender. You can make sure you get the best rate by shopping around with multiple lenders to find the best deal.

Home equity loans often come with fees and closing costs ranging from 2% to 5% of the loan amount. Common fees include application fees, appraisal fees, title search fees, and attorney and notary fees. Be sure to also look at the fees and other costs, in addition to the interest rate, when you compare lenders.

How Do You Calculate Home Equity?

Home equity is calculated as the difference between the value of your home — the amount it could sell for today — and what you owe on the mortgage. For example, if your house is worth $500,000 and you have a current mortgage balance of $200,000, you would have $300,000, or 60%, equity in your home. If you own your home outright, with no mortgage, then its entire value is your home equity.

Another common way to express home equity is the loan-to-value ratio, or LTV. LTV is calculated by dividing your mortgage balance by your home’s value, with the result expressed as a percentage. In the example above, the LTV would be 40%.

You gain home equity in two ways: when your mortgage balance decreases as you make monthly payments, and when your home’s value increases — whether due to market conditions like the competitive housing market we’re seeing now, or if you add value to your home through home renovations.

How much can you borrow with a home equity loan?

The more equity you have in your home, the more you’re eligible to borrow. In general, you can borrow up to 85% of the equity in your home, minus your current mortgage balance. In other words, the combined loan-to-value ratio of your primary mortgage and your home equity loan typically cannot exceed 85%.

The exact LTV maximum will depend on your specific lender, how good your credit is, and what other debts you have. Some lenders may even allow borrowers to take loans of up to 90% LTV out, meaning they only have to keep 10% equity in the house.

A lower loan-to-value ratio means you have more equity in your home. This may give you a better chance of qualifying for a home equity loan or receiving a lower interest rate.

Most lenders also have minimum and maximum loan amounts aside from equity requirements. Even if you have a lot of equity in your home, you may still be limited by the lender’s maximum loan amounts.

How to Use Home Equity Loans

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You can use a home equity loan for just about anything — it doesn’t have to be home-related. However, home equity loans are most commonly used for large expenses like home improvements because they offer lower interest rates than credit cards and personal loans, large loan amounts, and long loan terms. Home improvements can often add value to the house, so many people consider it an investment that’s worth taking on debt for.

In addition, the interest paid on the loan can be tax-deductible if you use the funds to substantially improve a qualifying home, and the total debt related to the house (including the primary mortgage and any other home equity loans) does not exceed $750,000.

Besides home improvement, other common uses for a home equity loan include:

  • Consolidate debt: Debt consolidation is a strategy where you take out one large loan to pay off the balances of multiple smaller loans, typically done to streamline your finances or get a lower interest rate. Because home equity loan interest rates are typically lower than those of credit cards, they can be a great option to consolidate your high-interest credit card debt, letting you save money on interest in the long run and pay off your debt faster. However, be aware that turning your unsecured debt into secured debt will make it riskier for you as the borrower if you can’t make your payments later on.
  • Business expenses: If you want to start a small business or side hustle but lack the capital to get started, a home equity loan can get you the funding you need without many hoops to jump through. However, think carefully before you take out a home equity loan to fund your business venture: if you can’t pay back the loan, you could lose your house. You may also find that dedicated small business loans are a better option.
  • Medical expenses: You can avoid putting unexpected medical expenses on a credit card by tapping into your home equity before a major procedure. Or, if you have outstanding medical bills, you can pay them off with the equity in your home. Before you do this, though, see if you can negotiate a payment plan directly with your medical provider with better rates or terms.
  • College expenses: Some parents choose to use home equity loans to pay for their children’s college. If you qualify for federal student loans, it’s almost always a better option than a home equity loan or other private options like HELOCs or private student loans. Federal loans have better borrower protections and offer more flexible repayment options in the event of financial hardship. But, if you’ve maxed out your financial aid and federal student loans, a home equity loan can be a viable option to cover the difference.

Experts don’t recommend taking out a home equity loan, or any other kind of loan, for non-essential expenses like a vacation or wedding. Instead, try to save up for those expenses over time so you can pay for them in cash instead of going into debt.

Alternatives to a Home Equity Loan

While home equity loans are flexible options for using the equity you’ve built up in your home to fund various expenses, they are not the only method. Other methods include:

Requirements for a Home Equity Loan

To qualify for a home equity loan, you’ll want to make sure you meet these requirements:

  • A good credit score: Your credit score plays an important role in determining not only if you can get a loan, but what your interest rate will be. “A common baseline to be eligible for a home equity loan is 680, but the higher the credit score, the lower the interest rate will be,” Pepper says. You can check your credit score and credit report before you apply for a home equity loan to get a sense of where you stand.
  • Sufficient equity in your home: Most lenders will allow a maximum loan-to-value ratio of 80% to 85%, so you’ll need to have at least 15% to 20% equity in your home. You may be able to get a home equity loan with less equity with certain lenders, but you’ll typically need to have exceptionally good credit to qualify.
  • Sufficient income: Lenders want to make sure that you can pay back the loan, so they’ll only lend to those who can prove they have sufficient income. If you don’t have traditional employment or a stable source of income, you may have trouble qualifying for a home equity loan.
  • A low debt-to-income ratio (DTI): Your debt-to-income ratio is calculated by dividing your total monthly debt payments by your monthly gross income and shows what percentage of your monthly income is going toward debt obligations. Lenders want you to keep your debt-to-income ratio under a certain percentage to make sure you’re not taking on more debt than you can handle. Most lenders want you to have a debt-to-income ratio of 43% or lower, although exact requirements may vary by lender.

Pros and Cons of a Home Equity Loan

A home equity loan can be a flexible, low-cost way to finance large expenses, but it’s not without its risks and downsides. Here’s what you need to know about the pros and cons:

Where to Apply for a Home Equity Loan

If you’re considering getting a home equity loan, the first order of business is to shop around and compare offers from various lenders.

“Most large banks and financial institutions offer home equity loans, so it’s always a good idea to solicit a few quotes and compare the terms, especially the interest rate and other fees, to make sure you get the right loan for you,” Pepper says.

Read more: What Is A Second Mortgage And How Does It Work? | Bankrate

A good starting place is with the bank or credit union you are already a customer of. Working with your existing bank could get you a lower interest rate, says Russ Ford, financial planner and founder of Wayfinder Financial. Some banks offer interest rate discounts if borrowers set up automatic payments from an existing checking or savings account with that bank.

Who Should Consider a Home Equity Loan?

Taking out a loan against the value of your home is something you might consider “if you have to pay for something but don’t have the cash to do so,” says Michael Caligiuri, CFP, founder and CEO of Caligiuri Financial.

One of the most common reasons to get a home equity loan is for home remodeling and improvements. “Utilizing a relatively low-interest loan, especially if it is to cover the cost of a major home improvement or renovation, could be a smart financial move,” says Pepper. This is because the improvements or renovations can increase the value of your home in the long run and improve your quality of life.

Another good reason to get a home equity loan is to consolidate debt, which can save you a lot of money in the long run if you have a large amount of high-interest debt you anticipate needing a long time to pay off. How much you can save will depend on how much debt you have, the interest rate on your current debt, and the interest rate you can get on a home equity loan.

But, since home equity loans come with fees and closing costs, make sure you do the math to determine whether you’ll actually save enough in interest over time to offset the upfront costs. And, think carefully before you consolidate unsecured debt into a secured home equity loan, as that increases the risk to you in the event that you default.

Who Should Not Consider a Home Equity Loan?

Just because you have equity in your home doesn’t mean you should borrow against it. Taking on any kind of debt can have a huge impact on your financial life, and this decision should not be taken lightly. Before you take out a home equity loan, think carefully about how you’re going to use the money and whether you truly need to finance the expense or if it’s something you can save up for instead.

“You should not take a home equity loan for personal expenses such as a boat or fancy vacation,” says Lindsay Martinez, CFP, who owns financial planning firm Xennial Planning in San Juan, Puerto Rico.

Because home equity loans are secured by your house, you run the risk of losing your home if you default. That’s why you should be extra careful not to borrow excessively and to make sure you have a plan to pay back the loan.

Best Home Equity Loan Lenders

If you’ve decided a home equity loan is the right financing option for you and want to move forward, here are NextAdvisor’s picks for the best home equity loan lenders to work with:

  • Discover: Best for no closing costs
  • BMO Harris: Good for autopay discount
  • U.S. Bank: Good for larger loan amounts
  • Connexus Credit Union: Good for no home appraisal
  • Region Bank: Good for existing Regions customers
  • TD Bank: Good for mid-Atlantic and East Coast applicants
  • Flagstar Bank: Good for no prepayment penalties

Bottom Line

Getting a home equity loan is not a decision to take lightly, but it can be well worth it if you use the money to achieve your personal or financial goals. Most borrowers use the money for home improvement projects that can increase the value of their house in the long run, but there are several other ways to use a home equity loan. Just be sure to do ample research before committing to one, since you will need to pledge your home as collateral.

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