What is a home equity loan and how does it work?

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. But it carries some particular caveats as well.

What is a home equity loan?

A home equity loan is a type of second mortgage: It’s a loan 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. As with a regular mortgage, you receive the funds in a lump sum, then make regular monthly repayments amortized over the term of the loan.

Because your home is the collateral for the loan, the amount you’ll be able to borrow is related to its current market value. 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.

Home Equity Loans in 2023

The housing market has boomed over the past decades, which has pushed up the residence-related wealth of American homeowners. In all, U.S. households possessed home equity worth $31.6 trillion as of mid-2023, according to the Federal Reserve. While that’s off slightly from the record high of $32.2 trillion seen in mid-2022, it’s still up significantly, compared to pre-pandemic years. As of mid-2018, for instance, the U.S. collective home equity stake was worth $17.7 trillion.

That means American homeowners are sitting on large piles of equity. Real estate data firm CoreLogic reports that the typical mortgage-owning American homeowner had $274,000 in equity as of June 2023.

The combination of growing home equity and a sharp rise in mortgage rates means demand for home equity loans — along with HELOCs, their line-of-credit cousins — has risen, increasing 50 percent in 2022 compared to two years earlier, according to the Mortgage Bankers Association (MBA). The average size of a home equity loan issued in late 2022 was $61,114, and the average credit score of a home equity borrower was 752.

Home equity loan pros and cons

Pros

• Attractive interest rates: home equity lenders typically charge lower interest rates compared to the rates on personal loans and credit cards.  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).
• Tax advantages: You could be eligible for a tax break, in the form of a tax deduction  if you use the loan proceeds to substantially improve or repair the home. Check with a licensed accountant tax professional to learn more about this deduction and to determine if it’s available to you.

Cons

• 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).
• Lengthy, costly application: Applying for a home equity loan is akin to applying for a mortgage; though somewhat simpler, it often means lots of paperwork, a long process and closing costs.

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. It must be the collateralized property: If you could take out a loan on your primary residence to buy a vacation home, the interest wouldn’t be tax-deductible (because the second home isn’t backing the debt). Also, you must itemize deductions on your return.

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.

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.

Home equity loans vs. cash-out refi

Another option to convert a portion of your home equity into ready money  is through a cash-out refi. Unlike a home equity loan, a cash-out refi does not act as a second mortgage. Instead, it replaces your current mortgage with a new one for a higher amount. The difference is your outstanding balance and the amount you wish to pull out.

To illustrate, assume your home is worth $450,000 and you owe $275,000. The lender approves you to pull out 75 percent in equity, or $62,500 ($450,000 x .75 – $275,000). So, you’d get a new mortgage for $337,500 ($275,000 + $62,500) along with $62,500 in cash. (This illustration is simplified: It does not account for closing costs and other transaction-related fees.)

When the loan closes, the new lender also pays off your existing mortgage. The remaining loan proceeds are disbursed to you, and you’ll commence repayment on the new mortgage for the higher amount.

You’ll generally get a loan term between 5 and 30 years. And often, the interest rate is lower compared to home equity loans — more comparable to mortgage rates.

What can you use a home equity loan for?

Most lenders don’t impose spending restrictions on home equity loans. Common uses include debt consolidation for high-interest credit card balances or other loans, home repairs or upgrades, higher education expenses and medical debts. Some homeowners also use the funds to start a business, purchase an investment property or cover another major purchase.

The bottom line on home equity loans

If you have a sizable amount of equity in your home, it could be a viable option to access the funds you need. That said, you should have a steady source of income and a clear idea of how you’ll use the funds.

Remember, home equity loans are secured by your home, so they should only be used for essential expenses. It’s equally important to avoid borrowing more than you can afford to repay to protect your home from foreclosure.

Frequently asked questions

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  Are there closing costs on a home equity loan?

  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.
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  Does taking out a home equity loan hurt your credit?

  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.
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  How do you calculate home equity?

  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 your equity, you can use a home equity calculator.

Additional reporting by Allison Martin