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A home equity loan is one of several types of mortgages that allows you to borrow against the value of your home. If you are interested in understanding whether this kind of mortgage is right for you -- and what the alternatives are -- this guide will help.
What is a home equity loan?
A home equity loan is a secured loan (a loan you get by putting up collateral). In this case, your home serves as collateral to guarantee the debt. Home equity loans are also called second mortgages. You must have equity in your home to apply with one of the best home equity loan lenders.
Home equity loans are paid back on a fixed schedule. You receive a lump sum of money when you borrow, and you repay it on a timeline predetermined with your lender. The repayment period is usually between five and 30 years.
How does a home equity loan work?
You are eligible for a home equity loan only if you have equity in your home. That means your home is worth more than you owe on your current mortgage. If you have sufficient equity, you can apply for a mortgage of this type with a lender offering home equity loans.
Your lender will evaluate your financial credentials. The amount you can borrow and your interest rate is determined based on:
- How much your home is currently worth
- Your income and credit score
- The balance on your home loan
You will find out your interest rate and payoff time up front. Loans with higher rates are more expensive. A longer repayment time also makes your loan more expensive over time since you pay more interest, although each monthly payment is cheaper.
You can use the proceeds from a home equity loan for anything you'd like. The home guarantees the loan, and if you do not make payments, your home equity loan lender can foreclose on your home.
How much can you borrow with a home equity loan?
How much you can borrow with a home equity loan depends on how much you already owe and how much your home is worth.
Most mortgage lenders limit you to borrowing no more than 80% to 85% of what your home is worth. This includes your first mortgage and your home equity loan. Some lenders let you go up to 90%.
To understand this, take a simple example. Say your home is worth $100,000 and you owe $50,000. If you are allowed to borrow a total of 80% of your home's value across all loans, your maximum combined mortgage amount would be $80,000. Since you already owe $50,000, you would be able to take out a home equity loan for up to $30,000.
Types of home equity loans
Home equity loans can be broadly divided into two types:
- Fixed-rate home equity loans: These usually have a higher starting interest rate than adjustable-rate home equity loans. The rate is guaranteed for the life of the loan. You will not see rates, payments, or total costs rise.
- Adjustable-rate home equity loans: These are also called variable-rate home equity loans. They are tied to a financial index, and rates can change periodically. There is a chance your rate could increase, which could make total payoff costs and monthly payments higher.
It's a good idea to check current mortgage interest rates for both fixed- and adjustable-rate home equity loans to decide which is right for you.
More on variable rates
A variable-rate loan is much riskier because you take the chance of rates adjusting up -- especially if you're borrowing when rates are low. Be sure you know how high your rates could go before choosing a loan with a variable rate.
What can you use a home equity loan for?
You can use the proceeds of a home equity loan for virtually anything. Many people use home equity loans for consolidating debt. That's because home equity loans usually have lower interest rates than many other types of loans.
Home equity loans can also be used for home improvement. Home equity loan interest may be tax deductible if you use the proceeds from the loan to buy, build, or substantially improve the home serving as collateral for the loan.
Be aware of the risks
You take a risk when converting unsecured debt (a loan with no collateral), such as credit card debt, to secured debt. Be sure you can make the payments easily before putting your house on the line.
Home equity loan three-day cancellation rule
A three-day cancellation rule applies to home equity loans. This is an important consumer protection rule.
Under this rule, you have the right to cancel the transaction until midnight of the third business day after signing the credit contract. The clock starts when you receive a Truth in Lending disclosure providing the details of your loan. Creditors can't release the money from the loan until the third day has passed.
If you choose to cancel the contract, you must provide written notice to the creditor.
Home equity loan costs
Home equity loans can come with high upfront fees. They are often called closing costs because they are paid at the time you close on the loan.
Home equity loan closing costs usually run between 2% and 5% of the amount borrowed. They include:
- Appraisal fees
- Credit report fees
- Loan origination fees
- Document preparation fees
- Attorney fees
- Title search costs
- Notary fees
Some lenders allow you to roll these costs into your loan amount. This will mean you are borrowing more. If lenders advertise "no-closing-cost" loans, this is often what's happening. Some lenders also charge higher rates to cover closing costs in a "no-fee" loan, rather than adding the costs to your loan balance.
Is a home equity loan right for you?
A home equity loan has some significant advantages, but also some disadvantages. Consider the pros and cons of a home equity loan when deciding if it is right for you.
Pros of home equity loans
Here are some of the biggest advantages of home equity loans:
- You can often borrow at an affordable rate
- You have the option to choose a fixed-rate loan, which provides certainty in terms of total costs and monthly payments
- Interest may be tax deductible in some circumstances
- You have flexibility in what you can use the loan proceeds for
- You will know your repayment timeline and total payoff costs up front
If you know exactly how much you want to borrow and can qualify for an affordable home equity loan, this type of mortgage may be right for you.
Cons of home equity loans
There are also some downsides to home equity loans:
- You put your home at risk of foreclosure if you don't make your payments
- The interest rate is typically higher than with a first mortgage
- You could end up owing more than your home is worth if you take too much equity out of your home
- You must know up front how much you want to borrow
- You must have equity in your home to qualify
If you aren't sure how much you'll need to borrow or aren't confident that you'll be able to make monthly payments, you may want to steer clear of a home equity loan.
Alternatives to home equity loans
Here are some alternatives that also allow you to tap into home equity.
Home equity loans vs. home equity lines of credit
Deciding between a home equity loan or a home equity line of credit (HELOC) can be tricky because both allow you to take out a second loan to access equity in your home.
There are big differences between them though. Here's what they are:
| Home Equity Loan | HELOC |
|---|---|
| You borrow a set amount | You borrow up to a certain amount (like a credit card); as you pay it back, you can draw from your credit line again |
| You have a set repayment schedule and know total costs | Often don't have predictable costs or payoff schedules |
| Fixed-rate loans are available | Most are variable-rate loans (some lenders offer fixed-rate loans) |
Home equity loans vs. cash-out refinance
A cash-out refinance loan also allows you to tap into your equity. But it works differently than a home equity loan.
With a cash-out refinance loan, you don't get a second mortgage. Instead, you take out one new mortgage to pay off your existing home loan -- but you also borrow more than you currently owe so you end up with extra cash. For example, if you owe $50,000 on a $100,000 home, you could take out an $80,000 cash-out refi. You'd use $50,000 of the proceeds to repay your current loan and walk away with $30,000.
Cash-out refinance loans can have lower rates than home equity loans and could potentially save you money on your existing home loan. But they make sense only if you can reduce your current loan rate.
How to find a home equity loan lender
Many lenders offer home equity loans. Choosing a mortgage lender can be complicated as a result.
To make it easier, get quotes from several loan providers to find the best mortgage lenders for your situation. When comparing quotes, consider:
- Qualifying requirements
- How much the lender allows you to borrow
- Options for repayment timelines
- Closing costs and fees
TIP
Prepare your credit
Improving your credit score before applying for a home equity loan can help you qualify for a better rate. You can improve your score by repaying debt, writing a goodwill letter to ask creditors to remove negative information from your credit report, or asking a loved one with a solid credit history to add you as an authorized user to one of their cards.
Still have questions?
Here are some other questions we've answered:
FAQs
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Yes, a home equity loan is a type of mortgage. It's often referred to as a second mortgage. It is a secured loan guaranteed by the value of your home. As a result, if you do not pay a home equity loan, a lender can foreclose and take your home.
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You can use a home equity loan for almost anything you'd like, like home repairs or debt consolidation.
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Yes, home equity loans have closing costs. They are usually between 2% and 5% of the value of the loan. Some lenders advertise no-closing-cost loans, but you still end up paying the fees -- either because you are charged a higher interest rate or the fees are tacked onto your loan balance.
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A home equity loan is a secured loan guaranteed by the value of your home, which serves as collateral. In some cases, interest on home equity loans is tax deductible if you use the proceeds to buy, build, or substantially improve the home and if you itemize on taxes.
Personal loans can be unsecured, which means there is no collateral guaranteeing the loan (although there are some secured personal loan options). Interest is usually higher on personal loans, but the initial fees are usually lower than closing costs on a home equity loan. Interest isn't tax deductible on personal loans.
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Yes, a home equity loan must be paid off when you sell your home. This is why it's important not to take out too large of a home equity loan. If you end up owing more than the home is worth, it will be difficult to sell. You'd need to come up with the extra money to pay back your home equity loan lender.
Our Mortgages Expert
Christy Bieber is a full-time personal finance and legal writer with more than a decade of experience. She has a JD from UCLA as well as a degree in English, Media and Communications with a Certificate in Business Management from the University of Rochester. In addition to writing for The Ascent and The Motley Fool, her work has also been featured regularly on MSN Money, CNBC, and USA Today. She also ghost writes textbooks, serves as a subject matter expert for online course design, and is a former college instructor.
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