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What Is a Home Equity Loan?

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Updated December 6, 2023

A home equity loan is a type of installment loan that lets you access the value in your home. Also known as a fixed-rate second mortgage, it essentially enables you to turn a portion of the value of the stake you own in your property into cash. The funds are paid out in a single lump sum, and the money can be used for a variety of purposes, including home improvements, education expenses, big-ticket expenses, and debt consolidation.

In this article we explain how a home equity loan works, its pros and cons, and the difference between a home equity loan and a home equity line of credit (HELOC).

How does a home equity loan work?

A home equity loan is a second mortgage that gives you a single lump sum payment. You pay the loan back in set monthly payments over the repayment period. Because the interest rate is fixed, you can expect to pay the same amount each month.

Home equity loans are secured, meaning should you have trouble making payments, the lender can seize your home as a form of collateral.

The loan amount you qualify for is calculated on the difference between your home's current market value and the balance due on the mortgage. This is what's known as the loan-to-value ratio (LTV). Usually, lenders want you to have at least 15% to 20% equity in your property for a home equity loan.

Home equity loans vs. home equity line of credit

Both home equity loans and home equity lines of credit (HELOCs) are secured loans and are backed by the equity in your home.\ \ However, there are some key differences. A home equity loan is a type of installment loan, where you receive a single payout upfront and pay back the loan in monthly installments. A HELOC, on the other hand, is a type of revolving credit and works like a credit card. You borrow from the credit limit, pay it back, then borrow from it again and again during the borrowing period, which can range from five to 20 years.

Another key difference is borrowing rates. While most home equity loans have a fixed interest rate, HELOCs come with variable interest rates, which are connected to an index such as the prime rate.

Home equity loan pros & cons

Let's look at some advantages and disadvantages of a home equity loan.

Pros

  • Can be easier to obtain than some other types of loans, such as personal loans.
  • Usually charge lower interest than personal loans.
  • Fixed interest rate: monthly payment remains the same throughout the length of the loan.
  • Longer repayment periods.
  • Get a lump sum upfront.
  • Flexible in what you can use it for.
  • If put toward building, repairing, or updating your home, might be tax deductible.

Cons

  • Can put you into a never-ending debt cycle.
  • Slower to process than credit cards and personal loans.
  • Can lose your home if you don't keep up with payments.
  • Might end up getting more money than you need.

When should you get a home equity loan?

A home equity loan might make sense if you plan on using the proceeds toward home improvements, college expenses, to cover an emergency cost, or to consolidate debt, which can all help your financial situation in the short and long term. Note that if you don’t use the home equity funds to “buy, build, or substantially improve” the home that backs the loan, interest payments are not tax deductible through the 2025 tax year, due to the Tax Cuts and Jobs Act of 2017.

A home equity loan might also make sense if you have strong credit and can get a low interest rate—one that's lower than a personal loan or credit card. It might also be a good choice if you feel comfortable offering your home as collateral and are confident that you will be able to repay the loan.

How to qualify for a home equity loan

To qualify for a home equity loan, you generally need the following:

  • At least 15% to 20% equity in your home.
  • A good or excellent credit score. The higher the score, the better. But generally, lenders want you to have a minimum credit score of 620.
  • Low debt-to-income ratio (DTI), which is your total monthly debt payments divided by your gross monthly income.
  • Steady, sufficient income for at least two years.
  • History of making on-time payments.

Lenders will also ask you how you plan on spending the funds and how much you would like to borrow.

How to apply for a home equity loan

Home equity loans are offered by banks, credit unions, and online lenders. You can usually apply either online, over the phone, or by visiting a brick-and-mortar location.

Before you apply, see if you can be prequalified. This helps you determine the loan amount and rates you most likely be offered from the lender where you apply. A good rule is to obtain quotes from at least three lenders.

The prequalification process also is a good opportunity to gather the necessary information and documentation, which can include:

  • Personal ID: government-issued ID, such as a passport or driver's license.
  • Proof of income: pay stubs, W-2 forms, bank statements, tax returns, bank or credit union statements.
  • Property information: original purchase price and date, date the home was built, mortgage statement, copy of the deed, estimated property value, tax assessment, current taxes due.

Each mortgage lender will have slightly different criteria and requirements. What else they might ask hinges on your individual situation.

A home equity loan is definitely worth considering if you're a homeowner, have strong credit, are in need of an influx of cash, and are comfortable putting your house on the line.

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