How Does a Home Equity Loan Work?


A home equity loan can allow you to access large sums of money without selling your home. Using your home as collateral, you can get a loan to finance anything you want — the choice is up to you.

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There is a bit you should know before jumping all in. Any time a loan requires collateral, it’s always best to read the fine print. Keep reading to learn more about the details and see if a home equity loan is right for you.

What is a home equity loan?

Let’s start by explaining what home equity is. Home equity is the amount of your home’s value that you own beyond your mortgage.

In other words, it’s what you could sell your house for right now minus what you still owe on your mortgage. For example, if your current mortgage is $150,000, but the house appraises for $280,000, then you would have $130,000 in home equity.

How does a home equity loan work?

A home equity loan is a loan where you, the homeowner, use the equity in your home as collateral to borrow money.

But here’s the catch.

Just because you have $130,000 in home equity doesn’t mean that’s what is available to you from the bank. Lenders typically only approve home equity loans for up to 80% of the home’s value. So in this example, the lendable value of the home is $224,000. When you subtract your $150,000 mortgage balance, that leaves you with $74,000 available to you via a home equity loan.

Of course, there are other variables the lender considers as well.

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Requirements to Get a Home Equity Loan

Home equity loans used to be a sure thing. You could just walk into a bank and take out a home equity loan if you had equity in your home.

Then the 2008 housing crisis happened, and everything changed.

Now lenders are pickier and comb through every detail of each application. They have also started limiting the loan amount to only 80% of your home’s value, whereas 90% to 100% used to be commonplace.

Before approval, you’ll also obviously need to demonstrate and prove that you can repay the loan. If you argue that you have immediate plans to sell after renovation, prepare to be disappointed. Plans alone won’t suffice. A secure and constant revenue stream is definitely needed.

Most lenders require a debt-to-income ratio of 43% or less. So, the monthly payment for your home equity loan, in conjunction with your other monthly debt payments, can’t exceed 43% of your monthly pre-tax pay. Depending on your finances, this could limit just how much equity you’re able to tap into.

Home Equity Loan vs. Home Improvement Loan

Is a home equity loan the same thing as a home improvement loan?

No, they are very different. For example, you could use a home equity loan to finance needed repairs or home improvements. However, you could not use the funds from a home improvement loan as you would a personal loan.

A home improvement loan also doesn’t consider the equity you have in your home, nor does it require any collateral. Instead, you use it for anything that revolves around the “improvement” of your home — be it to install a swimming pool, remodel a kitchen, or repair a roof.

Lenders usually require you to provide a detailed plan of what you would use the money for. Additionally, the repayment periods are a lot shorter than home equity loans.

Home Equity Loan vs. Second Mortgage

Is a home equity loan the same as taking out a second mortgage?

Generally speaking, yes. People tend to confuse home equity loans with home equity lines of credit. A home equity line of credit (HELOC) is an adjustable-rate loan and can be a second mortgage, but it doesn’t have to be.

You can get a HELOC after you’ve paid off your mortgage, in which case the HELOC would be your first mortgage. However, rather than receiving a single payment as you would with a home equity loan, a HELOC lets you draw from an account as you need funds.

Home Equity Loan Benefits

There are quite a few pros and cons associated with home equity loans for borrowers and lenders.

From the buyer’s side:

For starters, home equity loans tend to be easier to get than other types of loans if you have bad credit. So if you’re getting turned down by multiple lenders, it’s a great alternative to traditional personal loans.

Secondly, most home equity loans have lower interest rates than unsecured loans, which will help you pay less over time. And you can use the funds to pay off credit card debt with higher interest.

Your credit score will directly affect the interest rate you get. The higher your credit score, the lower your interest rate will be.

Plus, there are some tax advantages. Not everybody qualifies, but all the interest you pay is tax-deductible if you do. That means you’ll pay less in taxes come April. Lastly, if you have a fair amount of equity in your home, you can borrow money against the equity.

And for the lenders:

Home equity loans are safe loans to make for a bank because they’re secured by the homeowner’s house. If the homeowner fails to make mortgage payments, the lender can seize the home to recoup the funds they’ve lost (which is how some of those blue foreclosure dots end up on Zillow).

Borrowers are always more likely to make a monthly payment on a loan if it’s secured by something valuable. Most of the time, they’ll choose to miss a credit card payment over a loan payment if they have to make a choice.

Home Equity Loan Drawbacks

The main con is the most obvious one: you could lose your home if you’re unable to make loan payments. Many times we’re put between a rock and a hard place.

It may not be the best loan for you if you have a real chance of not being able to pay both your mortgage and equity loan in the future. Unsecured installment loans may be a better option. However, the interest rate will be higher.

Another thing you should know is that the home equity loan market is rife with scammers. Some lenders will take advantage of any opportunity to rid you of your home at the first chance they get. So, if the company that’s caught your eye seems too good to be true, it most likely is.

How does a home equity loan work?

First, let’s talk about how you receive your money. There are a couple of different ways. You can either receive money as a lump sum or as a line of credit.

Lump Sum

Get all your cash at once and begin paying back the loan with monthly payments. Home equity loans usually come with a fixed interest rate. Each monthly mortgage payment you make will go towards interest and the principal.

Line of Credit

Once you are approved for a line of credit, you can choose only to borrow what you need when you need it. It has a credit limit, much like a credit card.

Referred to as a HELOC (home equity line of credit), if you go this route, you can borrow multiple times and only have to make smaller payments as you do. You can do this for several years until you’re expected to start making larger payments to pay off the loan.

blue house

Home equity lines of credit are considered by many to be the best option because of their flexibility. You’re only expected to pay interest on the loan amount you’ve used in the beginning. However, with a variable interest rate, some monthly payments may be higher or lower than others.

Another downside to a HELOC is that if banks need to, they can cancel the HELOC before you’ve even gotten a chance to use it. If it happens to you, pay off whatever you need to pay off and go somewhere else. There are lenders everywhere.

Shopping Around for a Home Equity Loan

It’s always wise to shop around before settling with a lender. Interest rates can often vary significantly, and some lenders are more reputable than others. Moreover, many lenders require you to pay closing costs when taking out a home equity loan, but many won’t.

Do your homework and calculate which one will save you the most money over time. For example, a company may charge you closing costs, but if their mortgage rates are a lot lower than everyone else’s, they may be the best choice.

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

Home equity loans typically have terms ranging from five to 20 years, but some can last up to 30 years. With a fixed interest rate home equity loan, you’ll have fixed monthly payments until the loan is paid off.

If you take out a home equity line of credit, you’ll only have to pay the interest each month on what you’ve drawn. The draw period can last only a few years or up to ten years (depending on the lender). Once the draw period is over, your payments become regular payments, so each month’s payments will go towards both the interest and principal.

It is possible to pay off either type of loan early, but, once again, depending on the lender, there may be fees involved.

Can you sell your home if you get a home equity loan?

Yes, you can. It’s considered a lien on your house, so it’s settled at closing. Your loan is added to whatever you still owe on your mortgage. The sum of both is subtracted from whatever you sold your house for, with the remaining profits going to you (and, of course, Realtor fees).

Problems arise if the housing market collapses after you’ve taken out a home equity loan and the value of your home tanks. If you sell your house in this situation, what you make on your house will unlikely pay for what you still owe.

Banks don’t like giving out loans to buyers for houses with liens because they represent a greater risk for them. So if you intend to sell your home soon, make sure you can pay off the loan either through the sales proceeds or other means like cash savings.

How does a home equity loan affect my credit?

As with any loan, it can help or hurt your credit scores in various ways. You shouldn’t expect much improvement in your credit scores unless you take out a large loan and make on-time payments for years and years.

The plus side

  • Make your monthly payments on time, and your Payment History category will get a boost.
  • If you get a HELOC, you’ll get a bump in the Debts Owed category because you’ll have more credit available to you.
  • No matter whether you choose a lump sum or line of credit, you should see a bump in Types of Credit.
  • Depending on how long it takes you to pay back the loan, if it’s for more than a few years, you’ll see a bump in Length of Credit History.

The negative side

  • Your credit score will be lowered if you don’t make your payments on time.
  • If you take out a large amount, your Balances Owed category could cause your credit score to go down a few points.
  • Because it’s simply a new credit line, your credit score will also lower due to the New Credit category.
Lauren Ward
Meet the author

Lauren is a personal finance writer who strives to equip readers with the knowledge to achieve their financial objectives. She has over a decade of experience and a Bachelor's degree in Japanese from Georgetown University.