What is a home equity loan and how does it work?
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Home equity loans allow homeowners to borrow against the ownership stake they’ve built up in their house. Funded in a lump sum, this type of secured debt offers several advantages versus other types of loans.
What is a home equity loan?
A home equity loan is a type of second mortgage with a fixed rate, secured by your ownership stake (equity) in your home. It offers a specific amount of funds, so it’s best for borrowers who know exactly how much money they need.
Because your home is the collateral for the loan, home equity lenders typically charge lower interest rates compared to the rates on personal loans and credit cards. Keep in mind, however, that the interest rate you receive on a home equity loan (as with other loans) will vary depending on your lender, credit score, income and other factors.
How a home equity loan works
When you take out a home equity loan, the lender approves you for a loan amount based on the percentage of equity you have in your home. You’ll receive the loan proceeds in a lump-sum and make fixed monthly installments that include principal and interest payments over a set period. Although terms vary, home equity loans can be repaid over a period as long as 30 years.
Since the loan is secured by your home, the property is at risk for foreclosure if you can’t repay what you borrowed. If that happens, it can cause serious damage to your credit score, making it harder for you to qualify for future loans.
If you use a home equity loan to make home renovations or repairs, the interest you pay on it might be tax-deductible. According to the IRS, you can deduct interest on a home equity loan that is used to “buy, build or substantially improve” the property.
Home equity loan requirements
Lenders have different requirements for home equity loans. Some typical requirements include:
- Credit score: At least in the mid-600s
- Home equity: At least 15 percent to 20 percent
- Employment and income: At least two years of employment history and pay stubs from the past 30 days
- Debt-to-income (DTI) ratio: No more than 43 percent
- Loan-to-value (LTV) ratio: No more than 85 percent
How long do you have to repay a home equity loan?
It varies by lender. However, most home equity loans come with repayment periods between five and 30 years. A longer loan term means you’ll get more affordable monthly payments. That said, you’ll also pay far more in interest. So, assuming you can afford the higher monthly repayments, selecting a shorter term maximizes overall cost.
The ideal is to find a compromise between the two: the maximum manageable payments and the shortest loan term.
Home equity loan pros and cons
- Attractive interest rates: Compared to other forms of financing like a credit card or personal loan, home equity loans have lower interest rates. This is because home equity loans are a type of secured debt, meaning they’re backed by some sort of collateral (in this case, your house) — which makes them less risky for the lender, compared to unsecured debt, which isn’t backed by anything.
- Fixed monthly payments: Home equity loans offer the stability of a fixed interest rate and a fixed monthly payment. This might make it easier for you to budget and pay each month. This also eliminates the possibility of getting hit with a higher payment with a variable-rate product, like a credit card or home equity line of credit (HELOC).
- Home on the line: Your home is the collateral for a home equity loan, so if you can’t repay it, your lender could foreclose.
- No flexibility: If you’re not sure how much money you need to borrow (you’re planning a big remodeling project, say), a home equity loan might not be the best choice. Because home equity loans only offer a fixed lump sum, you run the risk of borrowing too little. On the flip side, you might borrow too much, which you’ll still need to repay with interest (though you might be able to settle the debt early, if that’s the case).
Are there fees associated with home equity loans?
Home equity loans are essentially mortgages — in fact, “second mortgage” is a common term for them — and often they come with the same sort of surcharges your primary mortgage does. Some lenders might require you to pay an origination fee and closing costs — typically between 2 percent and 5 percent of the loan balance — for the privilege of borrowing their money. You might also pay a home appraisal fee.
Once the loan proceeds are disbursed to you, late fees could apply if you remit payment after the monthly due date or grace period (if applicable). Some lenders also charge a prepayment penalty if you decide to pay the loan off early.
HELOCs vs. home equity loans
A home equity loan isn’t the only option for borrowing against your equity. One alternative is a home equity line of credit, or HELOC. While a HELOC is also secured by the equity in your home and has similar requirements, it operates differently from a home equity loan.
With a HELOC, you can borrow money on an as-needed basis, up to a set limit, typically over a 10-year draw period. During that time, you’ll make interest-only payments on what you borrow. When the draw period ends, you’ll repay what you borrowed and any interest, usually over a repayment term of up to 20 years.
Unlike home equity loans, HELOCs have variable interest rates. Though average HELOC rates tend to be lower than home equity loan rates, your monthly payments could increase if interest rates increase.
Frequently asked questions
Some home equity lenders, but not all, charge closing costs on home equity loans. These fees might be lower than the costs you paid when you closed on your first mortgage, though.
Taking on any form of debt, including a home equity loan, has an impact on your credit score. After you close on a home equity loan, your score might decrease temporarily. Over time, as you continue to make payments on the loan, you might see your score improve, as well.
Your level of home equity — the percentage of the home you own outright —is your home’s current value minus your outstanding mortgage balance. To calculate the percentage of equity you have in your home, divide your outstanding mortgage balance by the estimated value of your home. The remainder is your home equity. If you need help estimating the value of your home or calculating your equity, you can use a home equity calculator.
Additional reporting by Allison Martin