What is a home equity loan and how does it work?
Much like your mortgage is a loan based on the appraised value of your home, a home equity loan is based on the amount of equity you've gained in the property. Home equity is essentially the gap between your home’s market value and the amount you still owe.
From the time you submit a down payment and begin making monthly payments on your mortgage, you are establishing equity in your house. This equity can be tapped into in the form of a home equity loan or as part of a refinance. As with any home loan, you’ll want to check current mortgage rates to make sure you’re getting the best deal.
Are you ready to explore uses for the value of your home? Apply now to see how you can secure your financial goals.
What is home equity?
Home equity is the percentage of your home that you own outright, or the difference between your home’s current value and remaining mortgage balance.
If you have a mortgage, you technically own only a percentage of your house. Your home equity reflects that percentage. If you don’t have a home loan, you own your entire home, so you have full equity in your property.
Home equity builds over time, and most homeowners have some home equity, whether they realize it or not.
Home equity can be tapped into for expenses that you are planning or that come up unexpectedly.
What is a home equity loan?
A home equity loan allows you to use your home as collateral to access cash in the form of a lump-sum payment. In effect, you are borrowing against the equity built up in your home at a fixed rate determined by current interest rates.
How does a home equity loan work?
Determining the maximum amount available for you to borrow requires a formula.
First equation: Current home value x percentage of home value you’re allowed to borrow = maximum amount of borrowable equity.
Second equation: Maximum amount of borrowable equity − remaining mortgage balance = maximum amount you can borrow from your home equity.
What can you use a home equity loan on?
Home equity can be accessed for a number of expenses you may have. While these are some popular ways borrowers use their home equity, the best way for other borrowers may not be the same best way for you to use your home equity.
The best way you can use your home equity is whichever way is most helpful for your situation. Here are some common and popular ways to use a home equity loan.
Renovations
Some home improvements, renovations, repairs or remodels can raise your home’s value, which could increase your home equity. Your home equity can help you cover the cost of most if not all of your planned home projects.
Some planned home renovations have a higher return on investment, meaning that they could increase your home’s value more than others.
Consolidating high-interest debt
If you have high-interest debts, you could consolidate them with a home equity loan.
Consolidating your debt under a loan with lower interest rates could save you on interest payments during the life of your loan.1
Depending on your loan amount, you might be able to use your home equity to consolidate multiple high-interest debts at once. Consolidating multiple debts this way could reduce the number of payments you will have to make monthly.
Make an investment
One way borrowers use home equity for investment is to make a down payment on an investment property.
Investment properties are not for personal use but are meant to be rented out or sold for a profit as the value increases. These properties are not primary residencies and are bought with the goal of generating cash flow.
Emergency funding
Unfortunately, not all expenses can be planned for. If there are unplanned or emergency expenses that pop up in your life, your home equity is available to help.
Car repairs, medical visits or home repairs can be hard to predict. If any of these happen and you don’t want to tap into your savings or don’t have the funds saved to pay for these expenses, your home equity could cover or ease those costs.
Home equity loan requirements
Each lender has its own qualifications for home equity loans, but if you meet the requirements, you'll generally be a good candidate for approval.
- Current home equity from 15% to 20% or more
- A credit score of 620 or greater
- Debt-to-income (DTI) ratio below 43%
- Appraisal to determine fair market value of your home
A low credit score is not necessarily a disqualifier for securing a loan, but it’s safer to be in the “good” or even “fair” credit score range when applying for a home equity loan.
Pros and cons of home equity loans
A home equity loan can be a great way to access funds. But like any loan, it has pros and cons.
Pros
- Provides borrowers with a loan at a fixed interest rate.
- The loan is dispersed as a lump-sum, which could be a great benefit for consolidating debt or making a large purchase.
- Consistent payments every month for a predetermined amount of time.
- Money is tax-deductible if used for home improvements.2
Cons
- The loan could strain finances.
- Your home used as collateral sets you up for foreclosure should you be unable to make payments on the loan.
- Expect to pay from 2% to 5% of the loan amount in closing costs.
- You reduce existing equity by accessing cash funds.
Home equity loan alternatives
Here are some other ways to get cash based on the equity you have built up in your home.
Cash-out refinance
A cash-out refinance3 replaces your current mortgage with one that has new terms and loan amount to match your home’s value.
You will only need to make one monthly home loan payment instead of the multiple ones you may have to with other options.
HELOC
A HELOC4, or home equity line of credit, typically opens a credit line based on the home equity you have. HELOCs work similar to credit cards, where you can tap into your home equity as you need it.
For the first part of your HELOC, you can draw what you need while only making interest payments on the amount you have borrowed. After your draw period, you will have to pay back your loan principal and interest without the ability to make any more draws on your line of credit.
A HELOC is a great way to tap into your home equity if you have any rolling expenses, as you can keep drawing funds you need up to your approved limit.
Reverse mortgage
A reverse mortgage5 uses the equity you’ve established in your home to flip the roles of the lender and the borrower.
In this case, the lender pays the borrower based on that equity. Keep in mind that while the lender will make monthly payments to the borrower, you are still responsible for any applicable taxes, homeowner’s insurance and association fees.
With a traditional mortgage, every payment you make builds equity in your home. Eventually, you’ll own a larger share of your house than the bank does, and one day, you’ll pay off that loan in full.
In many cases, that equity isn’t available to homeowners until they sell their property or take out a home equity loan. With a reverse mortgage, you can access a portion of your equity.
Common uses include daily necessities, in-home care or medications, home repairs or renovations, supplementing retirement income or purchasing a new home.
How to apply for a home equity loan
To apply for a home equity loan, you’ll need to provide income verification, tax returns, asset statements and personal identification. You’ll also want to be aware of your credit score.
Your lender can provide you with guidance on scheduling a home appraisal if one is needed.
Are you ready to get started on a home equity loan? Apply for a home equity loan online to begin the process!
1Savings, if any, vary based on the consumer’s credit profile, interest rate availability, and other factors. Contact Rate for current rates. Restrictions apply.
2Rate does not provide tax advice. The consumer should always consult a tax advisor for information regarding the deductibility of interest and other charges in their particular situation.
3Using funds from a Cash-out Refinance to consolidate debt may result in the debt taking longer to pay off as it will be combined with borrower’s mortgage principal amount and will be paid off over the full loan term. Contact Rate for more information.
4Rate home equity line of credit (HELOC) is an open-end product where the full loan amount (minus the origination fee) will be 100% drawn at the time of origination. The initial amount funded at origination will be based on a fixed rate; however, this product contains an additional draw feature. As the borrower repays the balance on the line, the borrower may make additional draws during the draw period. If the borrower elects to make an additional draw, the interest rate for that draw will be set as of the date of the draw and will be based on an Index, which is the Prime Rate published in the Wall Street Journal for the calendar month preceding the date of the additional draw, plus a fixed margin. Accordingly, the fixed rate for any additional draw may be higher than the fixed rate for the initial draw. This product is currently not offered in the states of New York, Kentucky, West Virginia, Delaware and Maryland. The HELOC requires you to pledge your home as collateral, and you could lose your home if you fail to repay. Property insurance is required as a condition of the loan and flood insurance may be required if your property is located in a flood zone. Borrowers must meet minimum lender requirements in order to be eligible for financing. Available for primary, second homes and investment properties only. Dependent on minimum credit score and debt-to-income requirements. Occupancy status, lien position and credit score are all factors to determine your rate and max available loan amount. Not all applicants will be approved. Applicants subject to credit and underwriting approval. Contact Rate for more information and to discuss your individual circumstances. Restrictions apply.
5 This is not a commitment to lend. Home Equity Conversion Mortgages (HECMs) are eligible for borrowers 62 and older. Borrower must pay property taxes, Homeowner’s insurance, HOA dues (as applicable), and maintain the home and using it as primary residence or the loan will need to be repaid. Otherwise, the loan must be repaid when the borrowers leave the home more than 12 consecutive months, transfer their property's title to another person, the last borrower passes away or sells the home. Prices, guidelines and minimum requirements are subject to change without notice. Subject to review of credit and/or collateral; not all applicants will qualify for financing. It is important to make an informed decision when selecting and using a loan product; make sure to compare loan types when making a financing decision. This material has not been reviewed, approved or issued by HUD, FHA or any government agency. Rate is not affiliated with or acting on behalf of or at the direction of HUD, FHA or any other government agency. To find a Reverse Mortgage counselor near you, search the HECM Counselor Roster at https://entp.hud.gov/idapp/html/hecm_agency_look.cfm or call (800) 569-4287.
