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

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If you need to borrow money and have enough equity in your home, taking out a home equity loan can be a good idea. A home equity loan lets you borrow against the equity in your home, usually at a lower interest rate than other types of loans.

However, this type of loan product isn’t right for everyone — it also comes with risks. Before you decide to use this loan option, make sure you fully understand what those risks are, what a home equity loan is and how it works.

What is a home equity loan?

A home equity loan, commonly referred to as a second mortgage, is a fixed-rate, lump-sum loan that’s secured by the equity in your home. Because the loan is secured by your home, lenders typically charge lower interest rates than they do for personal loans or credit cards.

For example, as of June 23, the average home equity loan rate was 5.36 percent, while the average personal loan rate was 10.49 percent and the average credit card rate was 16.09 percent. However, the interest rate you’ll receive on a home equity loan, personal loan or credit card will vary depending on your lender, credit score and income and other factors. If you have excellent credit, you might secure a lower interest rate.

How does a home equity loan work?

When you take out a home equity loan, a lender approves you for a loan amount based on the percentage of equity you have in your home. Some lenders may require that you pay closing costs. Once your funds are issued, you have to repay the loan in fixed monthly installments that include the principal and interest. Although terms vary, home equity loans can be as long as 30 years.

Since the loan is secured by your home, this puts your home at risk if you can’t repay what you borrowed. If you default on the loan, the lender can foreclose on your home. In addition, this will 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 may 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 home.

How to calculate the equity in your home

Your home equity represents the portion of your home you actually own; it is your home’s current value minus your outstanding mortgage balance. To calculate the percentage of equity you have in your home, you have to divide your outstanding mortgage balance by the estimated value of your home. If you need help estimating the value of your home or calculating your equity, use a home equity calculator.

For example, if your outstanding mortgage balance is $100,000 and your home’s estimated value is $250,000, then you have 40 percent equity in your home.

Home equity loan requirements

Although lenders have different requirements for home equity loans, you typically need a credit score at least in the mid-600s, at least 15 percent to 20 percent equity in your home, solid income and a debt-to-income ratio (DTI) that’s lower than 43 percent. Before you apply for a home equity loan, review the lender’s minimum requirements to see if you qualify.

In addition, lenders usually have a maximum combined loan-to-value ratio of up to 85 percent. This means you can only borrow 85 percent of your home’s value, minus your outstanding mortgage balance. For example, if your home is worth $250,000 and you owe $100,000, 85 percent of your home’s value is $212,500. If you subtract your balance from that amount, you get $112,500 — this is the maximum amount your home equity loan could be.

Differences between a home equity loan and a home equity line of credit (HELOC)

A home equity loan isn’t your only option for borrowing against the equity in your home. You can use a home equity line of credit (HELOC) instead.

While a HELOC is also secured by the equity in your home and has similar borrowing requirements, it operates differently from a home equity loan. A HELOC is similar to a credit card in that you can borrow money on an as-needed basis up to a set limit. Unlike home equity loans, HELOCs usually 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.

Also, a HELOC comes with a draw period and a repayment period. During the draw period, which typically lasts 10 years, you can borrow money from the line of credit and are responsible for making interest-only payments. When that period ends, the repayment period begins and you have to repay the principal, plus interest. During the repayment period, which often lasts 10 to 20 years, you cannot borrow money from the HELOC.

The bottom line

When deciding if taking out a home equity loan is a good idea, consider the benefits and costs. Although home equity loans usually come with lower interest rates than other types of loans, you risk losing your home if you can’t repay your loan. If you need more payment flexibility, consider choosing a HELOC instead.

However, if you decide that borrowing against your home isn’t right for you, research different loan options.

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