What Is a Home Equity Loan? Your Guide to When It’s a Good Option
A home equity loan is a type of second mortgage that lets you borrow cash using your home’s equity as collateral.
This guide breaks down what a home equity loan is — and when it makes financial sense — to help you decide whether tapping your home equity is the right move for your situation.
- A home equity loan lets you borrow against the value you’ve built in your home, typically at a lower interest rate than unsecured loans.
- Because your home is used as collateral, a home equity loan only makes sense when you have a clear plan for repayment.
- These loans are often used for major expenses like home improvements or debt consolidation, rather than everyday spending.
Home equity loans: What are they?
Home equity loans are a way to access a large sum of money at a low interest rate. You can get a relatively low rate because the loan is secured by your home equity — in essence, then, you’re converting some of your home equity into cash.
Home equity loans are one type of second mortgage. They’re called a “second mortgage” because most people who take out a home equity loan already have a first mortgage (the loan they used to buy their home). You can take out a home equity loan while you’re still paying off the mortgage you used to buy your home.
Curious how the process works? Here’s how a home equity loan works step-by-step.
Home equity is the portion of your home that you own outright, and it builds over time as you make mortgage payments. You can calculate roughly how much home equity you have by subtracting your outstanding mortgage balance from your home’s value.
Your home equity amount can fluctuate if home prices in your area either spike or drop significantly. If prices increase, you’ll find yourself with more home equity without having to lift a finger. But if they go down you can lose equity and, in a worst-case scenario, end up underwater.
You’ll build home equity much faster with a 15-year versus 30-year loan because your monthly payments will chip away at the loan’s principal balance faster.
The stakes are higher with a home equity loan because it’s secured by your home. If you fall behind on your payments and can’t catch up, the lender could foreclose on your house.
Common home equity loan requirements
Most lenders look for solid credit, manageable debt and enough equity (often requiring you to leave at least 15% equity in your home).
The credit score guidelines aren’t typically more strict than you’ll find with conventional purchase or refinance loans, but the debt load requirement may be. But any mortgage typically requires a stronger financial profile than an unsecured loan.
If you’re ready to see the typical thresholds, read our guide to home equity loan requirements.
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Home equity loan pros and cons
Pros
- Stable monthly payments. The predictability of a home equity loan’s payments can make budgeting easier.
- Tax benefits. The interest you pay may be tax-deductible if the loan proceeds are used to buy, build or improve a home.
- Lower costs and fees. Home equity loan closing costs are typically more affordable than what you’d pay with a cash-out refinance.
- Flexibility. Home equity loan funds can be used for any purpose.
Cons
- Possibility of foreclosure. If you default on the loan, your lender could repossess your house.
- High bar to qualify. The financial profile needed to qualify is stricter than you’d find with a credit card or personal loan.
- Multiple payments. You’ll have two monthly mortgage payments if you take out a second mortgage while still repaying a first mortgage.
At today’s rates, the monthly payment on a $50,000 home equity loan is about $392.
You’ll receive home equity loan funds in a lump sum and make monthly payments. The payment amount won’t change over the life of the loan, since the interest rate is fixed.
How much can I borrow with a home equity loan?
You’ll typically be able to borrow no more than 85% of your home’s value. Some lenders may set different maximums, but they all represent their limit using a loan-to-value (LTV) ratio that compares your loan amount to your home’s appraised value.
Some lenders may offer high-LTV home equity loans, in which case you may qualify to borrow all (or nearly all) of your home’s equity.
Use a home equity loan calculator to easily find out how much you can borrow.
Should I get a home equity loan?
A home equity loan could be a good idea for you if you’re using it to:
- Make necessary home improvements, especially those that will increase your home’s value.
- Pay off or consolidate debt.
- Cover career-enhancing expenses that’ll help you get a higher-paying job.
- Invest or fund a business venture that’ll turn a profit.
When is a home equity loan a bad idea?
If you’re tapping your home equity to pay for “wants” rather than “needs,” you’re entering risky territory. Putting your house on the line for nonessentials — especially ones that won’t return the value of your investment — doesn’t usually make good financial sense.
Home equity loans vs. alternative loan options
Besides using a home equity loan, other ways to tap into your home equity can include a HELOC, cash-out refinance or personal loan. It’s important to assess each option to make sure you choose the one that’ll work best for you.
- Home equity line of credit (HELOC): Similar to a home equity loan, a HELOC is a second mortgage that allows you to convert home equity into cash. A HELOC works like a credit card and comes with a variable interest rate. You can use, repay and reuse the credit line as many times as you need during the HELOC draw period, but once the repayment period begins, you can’t withdraw from the credit line anymore and must repay the loan balance in full, plus interest.
- Cash-out refinance: A cash-out refinance is when you take out a new mortgage to replace your current home loan. The new loan balance covers more than just your outstanding mortgage — it’s large enough for you to also pocket the remaining difference in cash.
- Personal loan: A personal loan is an unsecured loan that pays you a lump sum of cash. Unlike the other options, it doesn’t tie your new debt to your home. This can offer some peace of mind, but because there’s no collateral securing a personal loan, it generally comes with a higher interest rate.
Compare home equity loan alternatives
| Loan type | Best if … | |
|---|---|---|
| HELOC |
| |
| Cash-out refinance |
| |
| Personal loan |
|
Still not sure which option is right for you? Read our comparison articles for additional help:
Frequently asked questions
Yes, bad credit home equity loans are available from some lenders. However, be prepared for a much higher rate and less borrowing power than you’d see with loans for borrowers with high credit scores.
The principal balance of a home equity loan is not tax-deductible, but the interest you pay on it may be. According to IRS rules, if you used the funds to “buy, build or substantially improve” your home, you can deduct the interest. However, there are caps on how much interest you can deduct that vary depending on when you took out the loan and whether you’re a single or joint tax filer.
Yes, if it helps you improve your finances, it can be a good idea to take equity out of your house. However, you should avoid the temptation to purchase unnecessary items that won’t improve your situation using home equity. If you can’t make the loan payments and the lender forecloses, you could lose your home.
There’s no waiting period for home equity loans — you can pull equity out of your house at any time, as long as you can meet your lender’s requirements. Most lenders require you to maintain at least 15% equity, so you may not qualify if you made a low down payment or haven’t been in the house long. But, with a little searching, you can find lenders who set the bar lower.
Compare Home Equity Offers