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Home equity loans allow homeowners to borrow against the equity they’ve built in their house. Funded in a lump sum, this type of borrowing 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 the equity in your home. It offers a fixed amount of funds, so it’s best for borrowers who know exactly how much they need to borrow.
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, personal loan or credit card 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. Some lenders might require you to pay closing costs to get a home equity loan.
Once your funds are issued, you’ll repay the loan in fixed monthly installments that include principal and interest payments. 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. This 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 improvements, 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
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 rates. This is because home equity loans are a type of secured debt, meaning it’s relatively safer for the lender to offer. Here’s more on secured versus unsecured debt.
- 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 or save. 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 paying college tuition, say), a home equity loan might not be the best choice. That’s because home equity loans only offer a fixed lump sum, so 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.
HELOCs vs. home equity loans
A home equity loan isn’t the only option for borrowing against your equity. You could alternatively obtain 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.