Understanding the Basics of Home Equity Loans

Getty Images

If you own a home, it’s likely the biggest asset to your name. That value can be put to work for you in the form of collateral for a loan, which you can use for whatever purpose you want, from home improvements to paying for emergencies.

That’s the gist of what a home equity loan is: money you borrow against what your home is worth.

Here’s what you should know about home equity loans and how they work.

What Is a Home Equity Loan?

“A home equity loan is a loan where a homeowner is able to borrow money from a bank and the equity in their home serves as collateral to the loan,” is how Elliott Pepper, CPA, CFP and co-founder of Northbrook Financial, defines the term.

How Does a Home Equity Loan Work?

There are two basic forms of borrowing against the value of your home: a home equity loan or a home equity line of credit, also known as HELOC. The two should not be confused. With a home equity loan, you get a lump sum paid to you; with a HELOC, you have  a line of credit, up to a predefined maximum amount, that you can tap into for large expenses or to consolidate debt.

If you’re considering getting a home equity loan, keep in mind that since your home acts as collateral against it, the lender might repossess it if you default on the debt.

Types of Home Equity Loans

There are three main types of home equity loans. Let’s take a closer look at them.

Fixed-rate Home Equity Loans

A fixed-rate home equity loan is a lump sum of money paid out to you, with a fixed interest rate over time. That makes it an attractive option for large, one-time expenses, such as getting a new roof or funding a large-scale home renovation.

The more equity you have in your home, the more you’ll be able to borrow, typically up to 85% of that equity. Home equity is the current value of your home minus what you still owe on your mortgage.

Home Equity Line of Credit (HELOC)

A HELOC is a line of credit with a variable interest rate. You are given credit up to a predefined maximum amount, similar to how a credit card works.

You can tap into that credit for expenses such as home renovations, or to consolidate higher-interest debt. Because the credit line remains available for a long time — a typical term is 25 years — it’s a good way to fund ongoing home projects; it can also be a source of funding for future needs as they may arise.

Cash-Out Refinance

With a cash-out refinance, you pay off your existing home loan and get a new one that is larger than what you owe. You’ll then get a check for the difference in price.

How to Qualify for a Home Equity Loan

To qualify for a home equity loan, you’ll want to make sure you have these requirements in order:

• A credit score above 680
• At least 15% equity in your home
• An 80% or less loan-to-value ratio
• Sufficient income
• Reliable payment history

Your credit score will also play an important role in determining not only if you can get a loan, but what your interest rate will be.

“A common baseline to be eligible for a home equity loan is 680, but the higher the credit score, the lower the interest rate will be,” Pepper says. (Here’s how to check your credit score for free.)

Home equity loans have an annual percentage rate (APR) far lower than unsecured loans like credit cards, since they provide security for the lender in the form of the collateral.

As of May 2021, the average interest rate on a home equity loan is around 5.26%, according to data compiled by Bankrate (which shares an owner with NextAdvisor). With good credit, you can get a home equity loan with an APR under 4%, Pepper says. Because interest rates are currently low, if you have good credit and the rate on a loan you’re inquiring about is not below 4%, “there’s probably something off,” says Ford.

Most home equity loans have five- to 30-year terms.

The more equity you have in your home, the more you’re eligible to borrow; in general, you can borrow up to 85% of the equity in your home, depending on how good your credit is and how much other debt you have, the Federal Trade Commission says.

A key statistic in this regard is the loan-to-value ratio. Lenders will look more favorably upon — and give lower interest rates to — borrowers with a lower ratio, all else being equal. Often, the maximum acceptable is 80%, meaning the balance of the mortgage should not be higher than 80% of the home’s current value.

Paying back a home equity loan is a lot like paying back your mortgage: You’ll have  a fixed annual percentage rate, and make monthly payments over the life of the loan.

Borrowers can deduct from their taxes the interest they pay on a home equity loan, like they would from a mortgage, but there are some limitations.

For loans begun after Dec. 15, 2017, “taxpayers can only deduct interest on up to \$750,000 of qualified loans — this includes the value of your current mortgage and the home equity loan,” Pepper says. “Additionally, the proceeds from the home equity loan must be used to build or substantially improve your home.”

He also notes that it is an itemized deduction, meaning that depending on your circumstances, you might just be better off claiming the standard deduction, and therefore not deduct any home equity loan interest at all.

Where to Apply for a Home Equity Loan

If you’re considering getting a home equity loan, the first order of business is to shop around and compare offers from various lenders.

Pro Tip

There may be a lot of value stored in your home, but shop around before you tap into it with a home equity loan.

“Most large banks and financial institutions offer home equity loans, so it’s always a good idea to solicit a few quotes and compare the terms, especially the interest rate and other fees, to make sure you get the right loan for you,” Pepper says.

A good starting place is with the bank you are already a customer of. It may even be required that you have an account with the bank in order to get a home equity loan from it. Working with your existing bank could get you a lower interest rate too, says Russ Ford, financial planner and founder of Wayfinder Financial

Who Should Consider a Home Equity Loan?

Taking out a loan against the value of your home is something you might consider “if you have to pay for something but don’t have the cash to do so,” says Michael Caligiuri, CFP, founder and CEO of Caligiuri Financial.

One of the most common reasons to get a home equity loan is for home remodeling and improvements. “Utilizing a relatively low-interest loan, especially if it is to cover the cost of a major home improvement or renovation, could be a smart financial move,” says Pepper. This is because the improvements or renovations can end up increasing the value of your home in the long run, as well as result in a better quality of life.

Home improvement projects — such as painting, installing new floors, or even swapping your appliances for new ones — aren’t the only possible use of these loans, though.

Home equity loans can also be used to pay for college costs or pay back higher-interest debt, says Lindsay Martinez, CFP, who owns financial planning firm Xennial Planning in San Juan, Puerto Rico. But be careful: you would be borrowing against your home to pay for debt that’s unsecured, i.e. not backed by collateral. “You should not take a home equity loan for personal expenses such as a boat or fancy vacation,” she advises.

But taking out a home equity loan can be a way to access a huge source of value and put it to a good use, especially at a time — during the recession caused by the coronavirus pandemic — when people are facing economic hardship.

“Many people are very stressed from a liquidity perspective, and their only real option may be to obtain a fixed rate home equity loan,” says Michael Caligiuri, CFP, founder and CEO of Caligiuri Financial

Bottom Line

Getting a home equity loan is not a decision to take lightly, but it can be a financial lifeline in certain situations. Most borrowers use the money for home improvement projects that can increase value in the long run, but there are several other ways to use a home equity loan. Just be sure to do ample research before committing to one, since you will also agree to pledge your home as collateral.

Continue Home Equity Series