How Does a Home Equity Loan Work?

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If you’ve been paying your mortgage on time for years and the value of your home has gone up, you probably have some equity in your property. How can you leverage it to your advantage?

Enter the home equity loan. This type of mortgage allows you to draw on the equity to get cash you may need for major expenses, such as a new roof or a college tuition bill. Here’s what you need to know about home equity loans.

How a home equity loan works

Want to unlock your home equity? These loans are one way to do it. Also known as a second mortgage or a home equity installment loan, a home equity loan gives homeowners a lump sum of cash to borrow against the equity in their home. Home equity loans typically come with a fixed interest rate and may be repaid over a period of 10, 15, 20 or 30 years, depending on the terms. The payments you make will go toward both principal and interest. As with any type of mortgage, it’s important to make your payments on time. Lenders may try to foreclose on the homes of borrowers who default on their home equity loans.

To determine how much you can borrow with a home equity loan, lenders will look at your loan-to-value (LTV) ratio. This is calculated by dividing the total remaining balance of all your mortgages and your hypothetical home equity loan amount by the value of your property. Lenders generally don’t want the LTV to exceed 80% to 90%, said Jon Giles, head of home equity lending at TD Bank.

For example, let’s say a homeowner has a property worth $200,000 and she has $50,000 remaining on her mortgage. She could probably get a home equity loan for around $120,000, as that would put the LTV at 85%.

LendingTree, the parent company of StudentLoanHero, offers a home equity loan calculator that can provide insight on how much equity you may be able to borrow from your property.

What do you need to qualify for a home equity loan?

To get approved for a home equity loan, you’ll obviously need equity in your home and an acceptable LTV. Lenders will also evaluate your ability to repay the loan by checking your credit history and debt-to-income (DTI) ratio. Each lender has different DTI requirements for borrowers, but having a DTI of less than 43% will qualify you for a home equity loan at many banks. Generally, a credit score of 700 will qualify you for a home equity loan as well, although scores as low as 660 may be considered, according to LendingTree.

“Verification of income is one of the most important things,” said Giles. “Gather your W-2s, tax returns and other things that prove your income.”

When is a home equity loan a good idea?

A home equity loan can be a financially savvy way to cover certain expenses. But remember, you’re putting your home on the line, so take a hard look at what you plan to do with the money before you borrow it.

“A home equity loan should be used in ways that put you in a better financial position. When you’re borrowing against your home, always think about the return back to you,” Giles said.

The most common reason people take out a home equity loan is to do remodeling or upkeep of their home, Giles added. The new tax law allows homeowners to deduct some or all of the interest they pay on a home equity loan if they use the funds to substantially renovate their homes. Check with a tax professional to see if you’re eligible for the deduction.

Some borrowers also use a home equity loan to consolidate other debt or pay tuition. Others may use the funds to add to their real estate portfolio or make an investment. While there are no rules about what you do with the money, experts generally recommend spending it in ways that are likely to improve your finances or home’s value.

In other words, you might want to find another way that doesn’t use your home as collateral to pay for that dream vacation or speedboat.

The cost of a home equity loan

The beauty of home equity loans is that they come with minimal to no upfront costs. While you may need to pay an origination fee, borrowers generally don’t pay an application fee or closing costs. Lenders also typically cover any necessary home appraisal costs, said Giles.

However, if you happen to pay your loan off earlier than the agreed-upon term, you may incur prepayment penalties. These may include closing costs of 2% to 5% of the loan, appraisal fees, application fees and other costs associated with issuing the loan, he explained.

The biggest cost to be aware of with a home equity loan is the interest rate. It’s typically going to be a bit higher than what you’ll see on today’s primary mortgages. Lenders consider home equity loans to be higher-risk than primary mortgages because they wouldn’t be first in line to get paid back. The interest rate will be based on a variety of factors, including current market rates, the value of your home, your income, the loan amount and the repayment timeline.

“Do some comparison shopping to make sure you get the right one for you,” Giles advised.

What to watch out for

When used appropriately, home equity loans are largely considered a safe way to get a substantial amount of cash at a low interest rate, said Giles. With that being said, keep in mind that there is a real risk to using your home as collateral. If a dip in the housing market causes the value of your home to drop, you may end up underwater. Your lender also may foreclose on your property if you fail to make your payments on time.

“Understand why you’re taking out the loan and make sure you’re comfortable with your budget before you take out the loan,” said Giles.

Not all lenders are willing to waive certain fees, such as closing costs. Shop around until you find a competitive home equity loan. Read the fine print and ask questions to make sure you understand the terms and conditions of the loan.

Finally, watch out for predatory lenders or home improvement contracting schemes. While a contractor may offer to arrange financing on a new roof, for example, you may end up paying high interest rates and fees.

“Do your due diligence and make sure you’re borrowing from a reputable bank or financial institution that can provide proper documentation on the parameters of their product and proper disclosures,” Giles said.

Alternatives to home equity loans

Home equity loans are just one way to leverage the equity you’ve built in your home. Other types of mortgages may be a better fit for your financial situation.

  • Home Equity Line of Credit (HELOC): A home equity line of credit gives you access to money using your home as collateral. While a home equity loan gives you the money in a lump sum, a HELOC is more like a credit card that you can draw money from as needed for a set period of time. Typically, HELOCs have a variable interest rate. The repayment terms on a HELOC are also different from a home equity loan. HELOC borrowers can make interest-only payments during the draw period, then begin paying both the principal and interest for a fixed term.
  • Cash-out refinance: You may also be able to access your home’s equity with a cash-out refinance. It allows you to replace your current mortgage with a new loan for a higher amount of money based on the value of your property and your equity. You can use money from part of the difference to pay for anything you wish. Because a cash-out refinance will become your primary mortgage, it will generally have a lower interest rate than a HELOC or home equity loan.

Conclusion

A home equity loan can be a smart way for a homeowner who has diligently paid his or her mortgage and maintained the property to access equity on one of their most important assets. If you need a lump sum to cover home improvements, college tuition or debt consolidation, a home equity loan could be a good fit for your financial needs.

This article contains links to LendingTree, our parent company.

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