What is a home equity loan and how do you get one?

A home equity loan is a type of second mortgage secured by the equity in your home. It offers a set amount at a fixed interest rate, so it’s best if you know exactly how much money you need. You’ll receive the funds in a lump sum, then make regular monthly repayments, amortized over the term of the loan, typically up to 30 years.

Because your home serves as collateral for a home equity loan, the amount you can borrow is based on its current market value. The home equity loan interest rate you receive (as with other loans) will vary depending on your lender, credit score, income and other factors.

How do home equity loans work?

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 (among other factors). You’ll receive the loan proceeds in a lump sum, then repay what you borrowed in fixed monthly installments that include principal and interest over a set period. Although terms vary, home equity loans can be repaid over a period of up to 30 years.

Since your home secures the loan, the property could be foreclosed upon if you can’t repay what you borrowed. The lender has a right to seize it to recoup its money. If that happens, it can cause serious damage to your credit score, making it harder for you to qualify for future loans.

“Before getting a home equity loan, make sure you understand all the loan terms, including the interest rates, draw period and any fees and charges,” says Linda Bell, senior writer for Bankrate. “It’s important to only borrow what you can afford to repay comfortably.”

Home equity loan requirements

Different lenders have different requirements for home equity loans, but generally, the standards include:

• Credit score: Mid-600s or higher
• Home equity: At least 20% of the home’s value
• 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%
• Loan-to-value (LTV) ratio: No more than 80%

If you fall short in any of these areas, your chances of approval decrease significantly. And times are getting tougher for borrowing in general.

What should you use a home equity loan for?

You can use the funds from a home equity loan for any purpose. Some of the best reasons to use one include:

• Upgrading your home: Whether you’re looking to remodel your kitchen, add an in-law suite or install solar shingles on your roof, a home equity loan can be a smart way to pay for the enhancements. You’ll be improving your home, which means you’ll enjoy living there more, and when you’re ready to sell, the upgrade can make it more attractive (and more valuable) to buyers. Plus, you can qualify for some tax benefits — a deduction on the interest — when you use a loan to invest in the property in this way.
• Consolidating high-interest debt: If you’ve been struggling to pay off debts with high costs like credit cards, a home equity loan can reduce the amount you pay in interest. However, if you’re considering this route, there are two important caveats. First, you need to be genuinely committed to not letting those credit card balances build up again. Second, the amount of debt needs to be significant. Credit card balance transfers or debt consolidation loans can be a better option if you’re aiming to pay off less than $10,000.
• Covering large medical bills: Health care can be costly, and medical problems often arise unexpectedly. If you or a family member needs a procedure, treatment or long-term care that isn’t fully covered by insurance, a home equity loan could be a good way to handle these healthcare costs.

How much can you borrow with a home equity loan?

To figure out how much you can borrow with a home equity loan, you first need to understand how much home equity you have. Your equity is the difference between how much your home is worth and how much you owe on your first mortgage. For example, if your home’s current fair market value is $500,000 and you owe $250,000, you have a 50% equity stake.

Most lenders will let you borrow up to 80% of your equity stake (some let you go as high as 85 or even 90%). However, most home equity loan lenders will cap your total amount of home-secured debt — including your first mortgage — at 80% of the home’s market value. So, in that case, you would likely be able to borrow up to $150,000, taking your total mortgage debt to $400,000 (80% of $500,000). Bankrate’s home equity calculator can help you estimate your exact borrowing power.

If you need more flexibility, consider a HELOC

A HELOC — short for home equity line of credit — is also secured by the equity in your home and is similar to a home equity loan, but it operates a bit differently. 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. 

This means your payments may be smaller than those for a home equity loan, which includes both interest and principal. When the draw period on the HELOC 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, which means your monthly payments can change.

Home equity loan pros and cons

Pros

• Attractive interest rates: Home equity lenders typically charge lower interest rates than those on personal loans and credit cards. This is because home equity loans are secured debt, meaning your home serves as collateral for the loan. This makes them less risky for the lender than unsecured debt, which isn’t collateralized.
• Fixed monthly payments: Home equity loans offer the stability of a fixed interest rate and monthly payment, simplifying budgeting. This also eliminates the risk of a sudden increase in costs with a variable-rate product, such as a credit card or a home equity line of credit (HELOC).
• Tax advantages: You could be eligible for a tax deduction of the loan interest if you use the loan proceeds to substantially improve or repair the home. Check with an accountant or tax professional to learn more about this deduction and to determine whether you qualify.

Cons

• Risk of foreclosure: Your home is the collateral for a home equity loan, so if you can’t repay the debt, your lender could initiate foreclosure proceedings.
• No flexibility: If you aren’t sure how much money you need to borrow, 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. It often means lots of paperwork, a long process and closing costs.

Tips to get the best home equity loan rates

Here are some practical ways to boost your chances of getting approved for a home equity loan:

• Improve your credit: Home equity borrowers generally need better-than-average credit. You can improve your score by reducing your debt, paying bills on time and fixing errors on your credit report.
• Increase your equity stake: “Equity-rich” borrowers, who own more than 50% of their homes outright, make the strongest candidates. Increase your home equity stake by making extra mortgage payments and investing in renovations that enhance your home’s value. The more equity you have, the lower the lender’s risk.
• Pay down debt: Lower your debt-to-income ratio (DTI) by paying down your outstanding balances — try not to use more than about one-third of your available credit on any card. A lower DTI shows lenders you have a good balance between income and expenses, and that you can handle an additional monthly obligation.
• Shop around: Compare home equity loan terms and rates with at least three banks, credit unions or online lenders. Each lender has different criteria, so it’s best to shop around. Don’t be afraid to ask for a better deal. The worst they can say is no.

Additional reporting by David McMillin

Frequently asked questions

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

  Applying for and receiving any new 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 timely payments on the loan, you might see your score recover and even improve.

• How long do you have to repay a home equity loan?

  It varies by lender, but 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 with a longer term. If you can afford the higher monthly payments, 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?

  Fees for home equity loans vary by lender, which makes it very important to compare offers. Some home equity lenders require you to pay an origination fee and other closing costs, typically between 2% and 5% of the loan balance. 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).

• What is the best time to get a home equity loan?

  The best time to obtain a home equity loan is when you have accrued significant equity in your property while also maintaining a small mortgage balance, a strong credit score and a low debt-to-income ratio. Although most lenders require that you have at least 20% equity, there is typically no waiting period to apply for a home equity loan after purchasing a home.