What Is a Home Equity Loan and When to Use One

If you want to borrow money and are a homeowner, you might be interested in a home equity loan. Home equity loans are a second mortgage that uses your home as collateral. As homeowner equity has generally increased in recent years, home equity loans have surged to $23.6 billion, according to CoreLogic.

What is a home equity loan?

A home equity loan is a second mortgage on your home. This loan type allows you to borrow money based on how much equity you’ve accrued in the home. Home equity is the value of your home minus what you owe on your mortgage, assuming you have one. 

For example: Suppose your home is valued at $600,000 and you owe $400,000 on your loan. This means you have $200,000 in home equity. A home equity loan lets you borrow money based on this equity. 

How does a home equity loan work?

Here’s a general overview of how a home equity loan works:

What are the requirements for a home equity loan?

There are several requirements for being approved for a home equity loan:

• Equity in the home: Generally, you’ll need at least 15% to 20% equity to qualify. This varies between lenders. For a home valued at $600,000, for example, you’ll typically need at least $90,000 to $120,000 in equity to qualify for a loan.
• Good credit: There is no set credit score to qualify for a home equity loan, but like most loans, the higher your credit score the more likely it is to be approved and to get a good interest rate. A good credit score, 670 and above, is most desirable, but some lenders may qualify you with a credit score as low as 620. 
• Reasonable debt-to-income ratio (DTI): Your DTI represents how much your monthly debt payments are compared with how much income you earn. Generally, lenders prefer borrowers to have a DTI of no more than 43%, but some lenders could accept a DTI of 50% if your overall finances look good. 
• Property appraisal: Lenders require a professional property appraisal to determine the value of your home. Once they know your home’s value, they can determine the loan-to-value ratio (LTV), a number that represents how much money you can borrow.
• Provide documents: Lenders will likely request income verification, bank statements, employment verification, and other financial documents to determine whether you're likely to repay the home equity loan.

What can you use a home equity loan for?

Because you’re using your home as collateral, these loans are best suited for investments that can increase your net worth, such as home improvements or buying investment property. Other ways to use home equity loans are for consolidating debt or medical expenses. It’s not a good idea to borrow against your home to pay for a vacation or a new car.
 

Home equity loan vs. home equity line of credit (HELOC)

With a home equity loan or a HECOL, you’re borrowing against the equity in your home. The differences are in how these loan products are structured: 

• Home equity loan: You borrow a lump sum of money with a fixed interest rate and monthly installments.
• HELOC: You borrow money through a line of credit with a variable interest rate. During the draw period, you can borrow as needed up to your limit, similar to a credit card. You need only pay the interest each month during the draw period, although you could pay more. Once the draw period ends, the repayment period begins. During the repayment period, you can no longer borrow money and you start paying back the loan principal and interest in monthly installments.

Pros of a home equity loan

• Fixed interest rate: With a fixed interest rate, you’ll have consistent monthly payments, making it easier to budget.
• Lower interest rates: Because your home is collateral, home equity loans typically come with lower interest rates than credit cards and personal loans.
• Variety of loan terms: Home equity loans typically have payback terms between 5 and 30 years.

Cons of a home equity loan

• You put your home at risk: If you default on your home equity loan payments, your lender could foreclose. 
• You need to borrow a specific amount: If you’re financing a project, such as a kitchen upgrade, you’ll need to know what you need upfront; you won’t be able to borrow as you go. Also, you pay interest on the lump sum, whether you use all the money or not.
• It could be difficult to qualify: Borrowers must meet the lender’s requirements to be approved for a home equity loan, such as having enough equity in the home, a good credit score, and an acceptable DTI.

Pros of a HELOC

• Line of credit: A HELOC works like a credit card but typically with a lower interest rate.
• Borrow only what you need: You only need to use your line of credit as needed. That way, you pay interest only on what you borrow. 
• Potentially high borrowing limits: This largely depends on your home's equity. Borrowers with a high-value home with a lot of equity, for example, might be approved for a HELOC of up to $1 million.

Cons of a HELOC

• Variable interest rate: Your interest rate may change over time in response to market fluctuations. When your rate changes, so do your monthly payments, making it more difficult to plan ahead.
• Temptation to spend: It’s best to spend HELOC funds on home improvements, debt consolidation, buying property, or medical expenses. But because you have a line of credit, it might be more tempting to use the money unwisely than if you take out a lump sum for a specific reason.
• Risk of losing your home: Like the home equity loan, there is a risk of losing your home if you can no longer make the monthly payments.