What Is a Home Equity Loan and How Does It Work?

As you pay off your mortgage, you slowly build up equity in your home. Over time, you own an increasing share of it.

A home equity loan is a financial product that allows you to access the equity tied up in your home without having to sell it first. You can then spend this cash on things you need, such as university fees, retirement costs, or even a new car. 

In this post, we ask: What is a home equity loan? We then take a look at how these products work and whether you should consider taking one out or not. 

Home Equity Loan Definition and Rates

Home equity loans, also sometimes called second mortgages or home equity installment loans, are a way of increasing the value of your outstanding mortgage balance in order to release cash.

The total amount of equity available is calculated as the market value of the home minus the value of the outstanding mortgage.

For instance, if a homeowner owns a property with a market value of $300,000 and has a mortgage outstanding of $100,000, they have equity of $200,000.

If they take out a home equity loan of $50,000, they reduce their home equity to $150,000 and receive $50,000 in cash. Their total mortgage burden then rises from $100,000 to $150,000. 

Home equity loan rates tend to be fixed – that is, the interest rate owners pay doesn’t change over limited periods. How much equity you release from your home is up to you.

You can take out a small amount or a large amount, depending on your circumstances. Note, though, that most banks have minimum loan amounts.

Home Equity Loan vs. HELOC

Home equity loans are not the same as the home equity line of credit. HELOCs have variable interest rates that fluctuate according to the Federal Reserve base rate. If the Federal Reserve raises rates, interest payments on HELOCs will also rise.

Home equity loans, on the other hand, are fixed for between five and 30 years. The home itself serves as collateral for the lender, who can foreclose it if you don’t make repayments on time.

Home Equity Loan vs. Cash-Out Refinance

You can also borrow against your home using cash-out refinancing. This form of credit is similar to a home equity loan in the sense that it lets you release cash from your home. However, there are also important differences.

Instead of adding a second mortgage, a cash-out refinance pays off your existing mortgage and then gives you a new, larger mortgage with a different rate, releasing cash into your bank account at the same time.

Under this arrangement, you only have a single mortgage repayment each month, not two.

In the event of a default or foreclosure, home equity loan lenders get paid second, while primary mortgage holders get paid first.

Hence, by converting home equity into a primary mortgage, lenders reduce their risk. This is why, in general, cash-out refinancing lets you access lower interest rates than a home equity loan.

In some cases, you may be able to get cash and reduce your monthly mortgage payments at the same time with a cash-out refinance.

If your credit score has improved, you may qualify for lower interest rates, cutting your monthly bills significantly while, at the same time, freeing up capital.

How Home Equity Loans Work

The best way to think of home equity loans is as a tool to increase the size of a regular mortgage in order to free up cash locked away in your home. When you release home equity, you’re selling a chunk of your ownership of your house back to the bank in exchange for cash.

The amount you can borrow depends on your combined loan-to-value (CLTV) ratio, which includes both your existing mortgage (if you have one) and your new home equity loan. Most banks accept CLTVs up to 90% of the home’s value. 

Going back to our example, if your home is worth $300,000 and you have a mortgage of $100,000 and your bank allows a CLTV of 9%, then you may qualify for a home equity loan of up to $170,000. 

While home equity loan interest is generally quite low, the actual amount you pay depends on your payment history and credit score. Individuals with high credit scores are liable to pay lower rates on fixed-rate home equity loans.

As with a regular mortgage, if you don’t pay on time, lenders may decide to foreclose on your property to satisfy any outstanding debt. 

When you take out your home equity loan, you’ll negotiate the length of the term with the mortgage provider. Most contracts are for five to 30 years, with the majority falling within the 10- to 25-year mark.

The shorter the mortgage repayment horizon, the more you’ll pay in each monthly installment for a given balance outstanding. Most lenders ask you to pay back both the principal and the interest, like a regular mortgage.

Equity home loans come with certain risks. For instance, if the market value of your property falls, you could wind up owing more than it’s worth. In that case, you may lose money on the sale of your home and be forced to downsize.

Pros and Cons of Home Equity Loans

As with any financial product, there are both advantages and disadvantages to home equity loans.

Pros 

• Predictable, fixed monthly payments made on top of your existing mortgage (if you have one)
• No restrictions on how you can use equity funds released from your lender
• Lower interest rates than virtually all conventional secured or unsecured consumer loans
• Longer terms than with the majority of consumer loans
• Immediate access to all funds

Cons

• Closing costs can be high compared to conventional consumer loans
• Risk of foreclosure if you default on the loan
• You need to clear both the remaining balance on your mortgage and home equity loan before you close on the sale of your home
• Home equity loan costs must be paid on top of existing mortgage costs

Terms for Home Equity Loans

Before you get approved for a home equity loan, make sure that you compare terms and interest rates across lenders. As with the traditional mortgage market, there are substantial differences among providers. 

Credit unions typically provide better interest rates than banks. However, application and processing times can be longer.

As with mortgages, you can ask for an agreement in principle to see how much money you could borrow and at what rate. Home equity loan amounts will vary according to your property’s market value, whether the bank believes its price will go up or down, your income, and your credit history. 

Generally, it’s a good idea to improve your credit score to reduce interest on any home equity loan you take out. You should also get a home appraisal before applying to take out a loan.

If the lender later discovers that your property is worth less than the money borrowed against it, they’ll reduce the loan amount, or deny your application entirely, and you won’t get any fees you paid back.

If you’re using a home equity loan to consolidate debt, then make sure that the repayments are actually lower than your current obligations.

Calculate the total amount you’re paying on your existing debts and then compare that to the monthly loan amount. In most cases, it will be lower, but not always. 

The 1986 Tax Reform Act eliminated tax deductions for interest paid on consumer expenses. However, there was a major exception: interest spent on servicing residence-based debt.

As such, home equity loans became dramatically more popular after this time, since people could release the equity in their homes and then use this to buy things they need, such as college tuition for their children. 

Aware of this loophole, the government introduced the Tax Cuts and Jobs Act of 2017. This legislation eliminated deductions for interest paid on home equity loans and HELOCs until 2026 unless used to make substantial improvements to the owner’s property.

For instance, under the new law, a homeowner could use the money to renovate their property, but not for vacations, college, or other consumer expenditures. 

Who Qualifies for a Home Equity Loan?

As with other sources of credit, lenders will examine your current financial situation. Home equity loan requirements include a good debt-to-income ratio, high credit score, and equity in your current home.

Equity

Most lenders will ask you to have more than 20% of your home’s value in equity before they’re willing to lend to you. For instance, if the market value of your property is $600,000, your outstanding mortgage should be no higher than $480,000.

To learn more about your equity, lenders may perform a home appraisal. This is where a professional expertly values your property based on the sale prices of similar homes in the local area.

Let’s say that the appraiser examines your home and determines its value. Here’s an example of a home equity loan calculation they might perform: 

• Value of property: $500,000
• Acceptable loan-to-value ratio: 0.9
• Outstanding mortgage balance: $150,000

To calculate the equity, subtract outstanding mortgage from the market value of the property: 

$500,000 - $150,000 = $350,000

Now calculate the maximum home equity loan value by multiplying the equity by the acceptable loan-to-value ratio: 

$350,000 ✕ 0.9 = $315,000

Hence, in this example, the homeowner can take out up to $315,000 in the form of a home equity loan. 

Debt-to-Income Ratio

Once the lender knows the value of your home, they will then investigate your debt-to-income ratio – the size of your monthly debt repayments compared to your monthly earnings. This information is important because it tells the lender more about your capacity to bear debts. 

To qualify for a home equity loan, you will need a DTI under 43% of your gross monthly income (income before taxes). 

To calculate your DTI, add up all your monthly debt repayments, and then divide by your gross monthly income. For instance, if your monthly income is $4,000 and your debt repayments are $1,000, then your DTI is 0.25, or 25% of your gross pay. 

You’ll need to supply at least two years of verifiable income history. If you can’t supply this, lenders may ask you to wait before reapplying for a home equity loan. 

Credit History

Lastly, lenders will explore your credit history to see if you have had issues making debt repayments in the past. They will then make a determination of your risk, based on the information they have access to via credit bureaus.

Even if you have a DTI over 43% and a valuable home, they may still deny you a home equity loan if your credit score is poor. Generally speaking, you need a credit score over 600 to qualify. 

When Should You Take Out a Home Equity Loan?

Traditional home equity loans have been around for a long time, but why do people use them?

To Pay Off High-Interest Debt

Because home equity loans are a type of secured debt, they tend to be considerably cheaper to service than regular consumer loans. Because of this, many people take them out to consolidate existing debt and reduce the overall cost of interest they must pay. 

To Pay for a Fixed Expense

People also release equity in their homes to pay for fixed expenses, such as college tuition or home improvements. In most cases, they know in advance the full amount they need to spend, and the precise amount of equity they need to release from their home. 

To Release Cash Fast

In some cases, you may simply require cash fast for a large and unexpected expense, such as care fees or medical bills. Instead of taking out a conventional high-interest consumer loan or putting the cost on a credit card, you might want to go for a home loan instead. 

In Conclusion

So, what is a home equity loan? Essentially, it’s a financial product that allows you to take out a second mortgage on your home, releasing any capital you’ve built up.

How does a home equity loan work? Simple. You apply to the bank for a new mortgage on your property and then pay installments separately from your primary mortgage.

This setup is different from either a HELOC or cash-out refinance, as explained above. 

To avoid foreclosure, you need to make monthly home equity loan payments on time. Banks will check your income and credit history to determine your level of risk, which, in turn, will determine the rate of interest you pay. In some situations, you may find you’re better off seeking alternative sources of credit.