What is a home equity loan, and how does it work?

You might be considering a home equity loan if you need funds to pay for a one-time emergency expense or if you’ve had an unexpected life change and need cash fast. Either way, it’s important to understand how home equity loans work before taking out a loan against your house.

What is a home equity loan?

A home equity loan is a loan in which borrowers use their house as collateral. You can get a home equity loan before or after you pay off your first mortgage, which is why it’s sometimes called a “second mortgage.” Home equity loans are conforming loans, so the minimum and maximum loan amounts are determined by the amount of equity you have in your property as well as federal regulations.

You can take out a large sum of cash upfront and repay the home equity loan over time with fixed monthly payments. Or, you can get approved for a home equity line of credit, or HELOC, which gives you access to the maximum amount available to borrow if needed. Either way, if you’re unable to keep up with rising interest rates, or if the value of your home suddenly drops, you’ll be at risk of foreclosure.

How does a home equity loan work?

When people refer to their “home equity,” they are talking about the difference between the market value of their house and how much they owe on it. Also sometimes called “real property value,” home equity increases as you make payments on your mortgage and when your property value appreciates. You use your home equity as collateral when you take out a home equity loan or a home equity line of credit.

A home equity loan is especially advantageous if your property values have gone up since you purchased your home. For example, let’s say that you’ve paid off half your mortgage on a house that you bought a decade ago for $100,000, and since then the value of the property has doubled. In this example, you currently owe $50,000 on a house that’s currently worth $200,000, and so your total home equity is $150,000.

The average person takes
5-15 YEARS
to pay off a home
equity loan

When you take out a home equity loan, you’re borrowing a large sum against your house under the condition that you’ll make payments every month until it is paid off. As part of the 2018 Tax Reform, interest on most home equity loans is no longer tax deductible.

Often, homeowners choose a home equity loan to consolidate their other debts. But keep in mind, too much debt will disqualify you for a home equity loan. Before you start applying for loans with your house as collateral, first you need to find out if you meet home equity loan requirements.

Home equity loan vs. line of credit

You should think of a home equity loan as a second mortgage, and there are two main types: fixed-rate home equity loans and home equity lines of credit (HELOC). Both home equity loans and HELOCs use your house as collateral, but they have some very important differences.

A home equity loan is best for people who only need to borrow a specific amount one time at a fixed rate. For example, if you’re making a one-time purchase of $30,000 for a home improvement project, a home equity loan is best.

Alternatively, a HELOC is more like a credit card. A HELOC is a line of credit based on your home equity that uses your house as collateral. Taking out a HELOC allows you to borrow up to a set amount over a period of time, usually 10 years. You’ll pay interest every month only on the amount you draw with options for interest-only payments. Most of the time HELOCs come with a variable or adjustable interest rate, which is good when rates are low but can be impossible to keep up with if they rise too quickly.

A HELOC is best for if you aren’t sure how much money you’ll need or if you want the option to borrow again. For example, if you’ll need money every year for four years to pay for your child’s college tuition, a HELOC might be a better option for you and your family.

Most borrowers find that HELOCs are easier to get than home equity loans, but their rates are variable. A home equity loan is less flexible than a HELOC, and you’ll be on the hook for interest for the full amount of the loan, no matter what you’re using it for.

A home equity loan will usually come with a fixed rate, and a home equity line of credit will usually come with an adjustable rate, though not always. Keep in mind that rates can change all the time, so even if you are able to get an adjustable interest rate on a home equity loan or line of credit, it may not be in your best interest if rates are currently low and are expected to rise.

Pros and cons of a home equity loan

When you first realize how much you can borrow with a home equity loan, it can feel like finding a huge pile of cash in your house that you didn’t know was there. But, there are very real risks involved. As with every financial transaction, there are benefits and disadvantages associated with home equity loans.

Benefits of home equity loans
On the plus side of a home equity loan, you’ll get fixed rates with predictable payments and lower interest rates than you would with a personal loan or credit card. If your mortgage rate is currently low, a home equity loan won’t change that.

Disadvantages of home equity loans
The most obvious disadvantage of any home equity loan or line of credit is that your house is at risk if you’re unable to make payments. There are also fees associated with home equity loans, like closing costs, and they can add up quickly.

Home equity loan alternatives

• HELOC: With a home equity loan line of credit, you’ll have access to a line of credit during the draw period instead of getting a large sum at once, like with a home equity loan or cash-out refinance. HELOCs are riskier for both the borrower and the lender because your payments will be less predictable. Sometimes, your HELOC lender will reduce or “freeze” your line of credit if the real market value of your house unexpectedly or significantly drops. Another key factor to keep in mind is that your lender could charge you a penalty or cancellation fee if your available line of credit remains unused or if you close your account within a certain period of time.
• Unsecured personal loan: With an unsecured personal loan, lenders determine the amount you can borrow based on your credit history and current income. Interest rates are sometimes double or triple that of home equity loans. Since the loan is unsecured, if you default on your loan you won’t lose your house.
• Credit cards: Like with a home equity line of credit (HELOC), you can take out a line of credit on a credit card. A credit card is a good option if you need funds quickly, but credit cards are more expensive in the long term, with APRs as high as 20 percent. It’s crucial that you pay your credit card off as soon as possible, preferably within a few months. Otherwise, your credit score could plummet and you could wind up owing significantly more money than the original amount you borrowed.
• Cash-out refinance: Cash-out refinancing is a way to pay off your first mortgage based on your home’s current value, whereas a home equity loan is another loan on top of your current mortgage. A cash-out refinance is similar to a home equity loan in that you’re liquidating your equity for more immediate funds. A lender will evaluate your loan-to-value limits to determine how much cash you can take out from the equity of your property. Interest rates are usually lower with cash-out refinancing than with a home equity loan, but not by much.
• Home improvement loan: Home improvement loans are ideal if you don’t have enough home equity to pay for a special project and you also don’t want another credit card. Since home improvement loans are unsecured loans, their interest rates are higher than home equity loans and home equity lines of credit.
• Manufacturer and dealer financing: Before you take out a home equity loan to purchase something like a vehicle or an expensive appliance, you should first look into financing options offered by the manufacturer or dealer. Instead of putting up your house as collateral, you’d just put up the product you’re financing. Terms and conditions will vary based on what you’re financing, but interest rates offered by manufacturers and dealers are typically lower than interest rates offered on home equity loans or HELOCs.
• Credit unions: If you have less-than-good credit, a credit union might be your best option for getting a personal loan. Usually, your local credit unions can offer lower rates than national online lenders.
• Federal programs: The Federal Housing Administration offers programs like Title I loans and Energy Efficient Mortgages that can help you secure funds to pay for home improvements and renovations.
• Sell your house: If you sell your house, you get instant access to your home equity. This is a great option for people who have a bigger house than they currently need or live in areas with expensive property taxes. If you have adult children, consider selling your house to them with a sale-leaseback agreement. A sale-leaseback agreement lets you sell your house and rent it back with cash from the sale.

Bottom line: Are home equity loans a good idea?

It can be tempting to access all the cash that a home equity loan can provide, but it’s important not to treat your house as an ATM. If you take out a home equity loan or line of credit, you can use the loan for whatever you want, though most people tap into their home equity to renovate their houses, further increasing their real property value. Other times, home equity loans are used to consolidate other debts or to refinance a mortgage. Some people even use their home equity to make a down payment on another house.

If you meet the requirements for a home equity loan and think a home equity loan is the best option for you, our best home equity companies guide can help you find the best lender.