Every mortgage payment chips away at what you owe and builds home equity, the value in your home that belongs to you free and clear of the mortgage. Many homeowners don’t think much about it until they need cash for something big, like an emergency home repair.
That’s where a home equity loan comes in. Used well, it can cover a need without derailing your finances. Used carelessly, though, it can put your home at risk. Here’s what to know before you tap into what you’ve built.
What is a home equity loan?
“A home equity loan is a second mortgage that allows homeowners to borrow money against the value they’ve built up in their home without changing their existing first mortgage,” explains Debbie Calixto, an Indian Wells, California-based sales manager at mortgage lender loanDepot.
“When you apply for a home equity loan, you’re putting your home up as collateral against the borrowed amount,” adds Ernie Wingard, RFC®, a North Richland Hills, Texas-based advisor at independent financial services firm Capital Choice Financial Group.
Homeowners may turn to home equity loans for “a major medical bill, a piece of equipment that breaks down at an established business or updating a home to prepare it for sale,” says Wingard. “It’s a way of putting your house up against some other financial goal.”
How does a home equity loan work?
With a home equity loan, you borrow a set amount of money based partly on the equity you have in your home. If approved, you receive the full loan amount as a lump sum when the loan closes. “If you’re approved, the bank gives you cash in the amount of the loan,” Wingard says.
You then repay the loan in monthly installments over a set term, often five to 15 years. Home equity loans typically have fixed interest rates, so your principal and interest payment stays the same throughout the repayment period.
Because a home equity loan is a second mortgage, it doesn’t replace your existing mortgage. Instead, you’ll generally have two separate monthly payments: one for your original mortgage and another for the home equity loan. And because your home secures the new loan, falling behind on payments could ultimately put your home at risk.
How does a home equity loan work?
With a home equity loan, you borrow a set amount of money based partly on the equity you have in your home. If approved, you receive the full loan amount as a lump sum when the loan closes. “If you’re approved, the bank gives you cash in the amount of the loan,” Wingard says.
You then repay the loan in monthly installments over a set term, often five to 15 years. Home equity loans typically have fixed interest rates, so your principal and interest payment stays the same throughout the repayment period.
Your home secures the loan, which means falling behind on payments could put your home at risk. A home equity loan also doesn’t replace your existing mortgage, so if you still have a mortgage, you’ll make payments on both loans.
Home equity loan vs. other ways to borrow
A home equity loan isn’t the only way to borrow money, and tapping your home equity isn’t always the right approach. The biggest difference is that home equity loans let you borrow against your home, while options such as personal loans don’t require you to put your home up as collateral.
Here’s how a home equity loan compares with some common alternatives:
| Home equity loan | HELOC | Cash-out refinance | Personal loan | |
| How you receive money | Lump sum | Borrow as needed from a credit line | Lump sum | Lump sum |
| Interest rate | Typically fixed | Typically variable | Typically fixed | Typically fixed |
| Uses home as collateral | Yes | Yes | Yes | Usually no |
| Affects existing mortgage | No | No | Replaces it | No |
| Best suited for | Large, known expense | Ongoing or uncertain expenses | Borrowers who also want to replace their mortgage | Borrowers who don’t want to use their home as collateral |
A HELOC, or home equity line of credit, may make more sense if you don’t know exactly how much you’ll need or expect to borrow money at different times. Instead of receiving one lump sum, you can draw from the credit line as needed during a set period.
A cash-out refinance works differently because you replace your existing mortgage with a larger one and receive the difference in cash. That can make the interest rate on your new mortgage particularly important.
A personal loan doesn’t tap your home equity at all and is usually unsecured, so your home isn’t at risk if you can’t repay it. However, interest rates may be higher than with borrowing that’s secured by your home.
When a home equity loan makes sense
“A home equity loan can make sense when you have a clear purpose for the funds and a realistic repayment plan,” says Esther Buede, the owner of Choice Home Mortgage, a family-owned mortgage brokerage in Orange County, California.
Here are three scenarios where a homeowner might consider getting a home equity loan:
- Financing a major home improvement: Buede says renovations are one of the most common uses she sees, since the money goes toward a project that can also raise your home’s value.
- Consolidating debt: A home equity loan can help you pay off high-interest credit card debt. But “it only works if you’re going to stick with the plan and pay the debt off quickly,” Wingard stresses.
- Investing in a strategic opportunity: “Some homeowners use equity to purchase an investment property, cover educational expenses or fund another financial opportunity that may provide long-term benefits,” Calixto notes.
When a home equity loan may not make sense
A home equity loan is riskier when the funds go toward something that won’t build value or improve your finances long-term.
Homeowners may want to reconsider a home equity loan in these scenarios:
- Starting a new business: “Most businesses fail, especially in the first year,” Wingard warns. So you’d be taking a much bigger gamble than borrowing to fix a breakdown at an established, revenue-generating business.
- Funding a vacation: “This offers zero opportunity of creating financial gain,” says Wingard. If you can’t cover a trip with savings, it’s a sign to wait instead of borrowing against your home.
- Funding everyday spending: “Using home equity to pay for day-to-day living expenses can leave you with more debt,” Calixto cautions.
What are the requirements for a home equity loan?
Lenders look at the following to see if you qualify and how much you can borrow:
- Available home equity: “Lenders typically only lend against about 85% of the property’s value,” Wingard explains. That means you’ll need to keep at least 15% equity untouched.
- Credit score: Lenders use this three-digit number to gauge how well you’ve repaid debt in the past. Aim for a FICO score of 620 to 680.
- Debt-to-income (DTI) ratio: This measures how much of your paycheck already goes toward debt each month. Lenders generally prefer this below 43%, though some allow more depending on your overall finances.
- Income and employment: Expect to provide W-2s, 1099s or tax returns showing steady income and at least two years of work history.
“Where borrowers most commonly fall short is with credit scores, excessive debt obligations or insufficient equity in the property,” notes Calixto. “Even when homeowners have substantial equity, lenders still want to see they have the financial ability to handle the new monthly payment comfortably.”
What affects your home equity loan rate?
A mix of factors shape your home equity loan rate, according to experts:
- Your remaining equity: “The more equity you have left after the loan, the more likely the bank thinks you are to keep making payments so that equity isn’t at risk,” Wingard points out.
- Property type and occupancy: “Pricing can differ depending on whether the property is a primary residence, second home or investment property,” Buede says.
- Your credit profile: A higher score helps, but lenders also weigh your payment history and overall credit behavior.
- Your loan term: Shorter terms often come with better rates, since the lender’s money is out for less time.
- Lender’s pricing: “Different lenders may have different pricing structures, risk tolerances and guidelines for the same borrower and property,” notes Buede. She recommends looking beyond a single advertised rate and comparing a few lenders before committing.
Step-by-step: How to get a home equity loan
After figuring out how much you need — and can afford — to borrow and comparing lenders, getting from application to funds in your account generally follows this path:
1. Submit your application
You’ll start by providing income and documentation, details about your existing mortgage and property information. Wingard says lenders usually ask for your current mortgage statement, pay stubs and tax statements.
2. Get your home appraised
Most lenders send someone out to appraise your home in person and confirm its current value. Buede notes that some loans may skip this step in favor of a faster, technology-based estimate called an automated valuation model (AVM).
3. Go through underwriting
Underwriting is the lender’s behind-the-scenes review of your finances. The lender assesses your credit, income, debts and equity position to confirm you meet its requirements.
4. Review your terms and sign
If approved, you’ll receive your rate, term and monthly payment. For a primary residence, you typically have a three-business-day window after signing to cancel if you change your mind.
5. Receive your funds
Once that window passes, the lender deposits your lump sum electronically, mails a check or has you pick it up in person.
Timing varies by lender. “Some home equity transactions can close in as little as five days, while others can take longer, particularly when a full appraisal is required,” Buede says. In a typical scenario with a full appraisal, she says the process takes about three weeks.
How to get the best home equity loan rates
Four practical moves can improve your odds of landing a lower home equity loan rate:
- Make on-time payments and monitor your credit history. “Don’t apply for any other credit while you’re doing this,” advises Wingard. “Minimize the amount of debt on your record before you apply so your score is as high as possible.”
- Get prequalified with a few lenders. Prequalifying won’t hurt your credit the way a full application does. It’s a low-risk way to compare offers before committing to a full application and appraisal.
- Consider borrowing less. “This can place you into a more favorable pricing tier, depending on the lender’s guidelines,” Buede points out.
- Document upgrades you’ve made to your home. Solar panels, a new pool or a major bathroom or kitchen remodel can boost your home’s appraised value, but only if the appraiser knows about them. Wingard recommends keeping records and handing them over before your appraisal.
Bottom line
A home equity loan is best suited for a single, well-defined expense — not a cushion for ongoing money trouble. And if your finances are already stretched thin, taking on another loan payment, even at a good rate, can make things harder.
Still not sure if a home equity loan is right for you? “An experienced mortgage professional can help compare available options, explain the true costs and ensure you’re choosing the program that best aligns with your long-term financial goals,” Calixto says.
Frequently asked questions
What are some alternatives to a home equity loan?
Some alternatives to a home equity loan include personal loans and home equity lines of credit (HELOCs). A personal loan doesn’t use your home as collateral, but usually costs more in interest. A HELOC suits ongoing or uncertain expenses since you only draw and pay interest on what you use.
Will getting a home equity loan impact my credit?
Yes. Applying for a home equity loan causes a small, temporary dip from the hard inquiry, and your payment history afterward will help or hurt your score over time. On-time payments can strengthen your credit, while missed payments can cause damage.
What’s the best time to get a home equity loan?
The best time to get a home equity loan is when you have at least 15% to 20% equity, favorable rates and strong credit and income. Having all three in place gives you the best shot at approval and pricing.
What happens if I can’t pay my home equity loan?
If you can’t pay your home equity loan, you’ll face late fees, credit damage and eventually default. Since your home is collateral, the lender can foreclose if the loan goes unresolved.