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How Does A Home Equity Loan Work?

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If you’ve significantly paid down your mortgage or benefitted from a home value boost, you might consider a home equity loan to access some of the untapped cash your equity can provide. Still, you may be wondering: How does a home equity loan work?

Home equity loans allow homeowners to pull from the equity they’ve built in their home over time, providing funds that can be used for anything from consolidating high-interest debt to making home improvements.

What is a home equity loan?

A home equity loan is a type of second mortgage that allows you to borrow against your home equity — the difference between your home’s appraised value and your outstanding mortgage balance. Similar to your first mortgage, your home is used as collateral for a home equity loan.

Home equity loans are disbursed in a lump sum and repaid in fixed monthly installments. Loan terms start at five years and, in some cases, can go up to 30 years.

How does a home equity loan work?

A home equity loan typically comes with a fixed interest rate and a set loan term with fixed monthly payment amounts. Just like the mortgage used to buy a home, borrowers make principal and interest payments over time until the loan is paid in full.

Common home equity loan uses include:

  • Covering college costs
  • Consolidating non-mortgage debt
  • Funding an investment property down payment
  • Paying home improvement expenses
  • Starting a small business venture

You will pay closing costs on a home equity loan, which can range from 2% to 5% of your loan amount.

Home equity loan vs. HELOC

A home equity loan isn’t the same product as another type of second mortgage, known as a home equity line of credit (HELOC).

A HELOC functions much like a credit card. Your lender provides you with a revolving credit line against your home equity and you can draw on it up to the credit limit. You only pay for the amount you borrow, plus interest charges.

Similar to a home equity loan, a HELOC uses your home as collateral. Unlike a home equity loan, HELOC interest rates are usually variable. You’ll have a set number of years — called a “draw period” — to access your credit line. After that point, you’d either repay the full balance at once or in fixed installments over time.

THINGS YOU SHOULD KNOW

If you’re taking equity out of your home to make home improvements, you may be able to deduct the interest you pay on the loan from your taxable income. The mortgage interest deduction applies to both home equity loans and HELOCs as long as you use the loans to buy, build or substantially improve the home securing them. The property either needs to be your main home or second home.

How to get a home equity loan

Review the following home equity loan requirements before applying for a home equity loan.

Home equity loan qualifications

Credit score  620 or higher
Debt-to-income ratio  43% or lower
Loan-to-value ratio  85% or lower
Loan term  5 to 30 years
Closing costs  2% to 5% of loan amount

How much home equity can you borrow?

In most cases, you won’t be able to borrow every dollar of equity you’ve built. Lenders often permit home equity loan and HELOC amounts up to 85% of your home’s value, minus your outstanding mortgage balance.

For example, let’s say your home is worth $250,000 and you owe $100,000 on your first mortgage. First, you’d calculate 85% of your home’s value, which is $212,500. Then, you’d subtract the $100,000 you still owe to determine the maximum amount of equity you may qualify to borrow, which is $112,500.

LendingTree’s home equity loan calculator can help you determine how much you may qualify to borrow.

Your loan-to-value (LTV) ratio also shouldn’t exceed 85%. An LTV ratio is the percentage of a home’s value that is financed by a first and/or second mortgage. Some lenders offer high-LTV home equity loans that allow you to borrow up 100% of your home’s value, however.

 

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