Home Equity Loans: Your Guide to Smart Borrowing

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Updated: November 21, 2024

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Unlike a traditional mortgage, which finances the purchase of a home, a home equity loan leverages the value already established in your real estate. It’s ideal for those with significant equity for home improvements, debt consolidation or other major expenses.

Here, we'll explore what a home equity loan is, its pros and cons, its requirements and the application process. We'll also compare it to a home equity line of credit (HELOC) — another financial product that leverages your home’s equity — so you can determine the best option for your financial needs.

Key Takeaways

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A home equity loan is a lump sum borrowed against your home's equity, best used for large expenses like home renovations or debt consolidation.

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Home equity loan rates are affected by your credit score and loan-to-value ratio, influencing the cost of borrowing.

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A HELOC has variable interest rates and a draw period, while a home equity loan offers fixed rates and a lump sum disbursement.

What Is a Home Equity Loan?

A home equity loan lets you borrow money against the equity in your home, providing a lump sum that you repay over time with a fixed interest rate. It's a popular choice for homeowners needing funds for large expenses like home renovations or debt consolidation. As of Q3 2023, the average debt balance for home equity loans has risen by 17.6%, totaling $139.3 billion, according to Experian.

In the following sections, we'll discuss how home equity loans use your home as collateral and their typical interest rates and repayment periods, giving you a clear understanding of how they work.

Collateral

A home equity loan is secured by your home, meaning your property acts as collateral for the loan. To determine the amount of equity in your home, subtract your remaining mortgage balance from your home's current market value. This equity helps lenders decide how much you can borrow.

Using your home as collateral often leads to lower interest rates compared to unsecured loans. However, it also means that if you fail to repay the loan, you risk losing your home. Long-term borrowing against your home's equity can impact your financial stability, so it's important to consider this carefully.

Interest Rates

Home equity loans typically have a fixed interest rate, offering predictable monthly payments. However, home equity loan rates fluctuate daily, affecting your borrowing costs. Understanding the factors influencing these rates can help you better prepare for the loan application process.

  • Creditworthiness: Your credit score, debt-to-income ratio and overall credit history can influence your home equity loan rates. A lower credit score may lead to a higher interest rate, reflecting the lender's increased risk.

  • Loan-to-value ratio (LTV): Lenders assess the ratio of your loan amount to your home's appraised value. A higher LTV ratio might result in a higher interest rate, as it indicates more risk for the lender.

  • Location: Regional economic conditions affect rates. For instance, home equity loan rates in Florida and home equity loan rates in Texas can differ based on local market stability and demand.

  • Loan amount: The size of your loan can impact your interest rate. Larger loans might come with a higher interest rate due to increased risk, while smaller loans may have more favorable terms.

  • Economic conditions: Interest rates are influenced by the broader economy, including inflation and Federal Reserve policies. Economic instability can lead to a higher interest rate as lenders adjust to market conditions.

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Repayment Period

Repayment periods for home equity loans typically range from five to 20 years. Payments are fixed, allowing you to repay the loan in predictable installments. This stability can make it easier to manage your finances over the loan term.

When you repay the loan, each payment reduces both the principal and interest. This ensures that your loan is fully paid off by the end of the term, providing clear financial planning.

Pros and Cons of a Home Equity Loan

A home equity loan can provide a lump sum of cash for large expenses, such as home renovations. However, using your home as collateral carries the risk of losing it if you fail to repay the loan. Below, we’ll explore the pros and cons of home equity loans.

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Pros
  • Fixed rates: Stable rates make budgeting easier, providing consistency over the loan term.
  • Predictable payments: Consistent monthly payments aid financial planning and avoid surprises.
  • Lower interest rates: Often lower than unsecured loans, saving money over time.
  • Possible tax benefits: Interest might be tax-deductible, lowering your overall tax burden.
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Cons
  • Two mortgage payments: Managing multiple loans can be challenging and strain finances.
  • Decrease in home equity: Reduces the value available in your home for future needs.
  • Closing costs and fees: Additional expenses at loan initiation can add up quickly.
  • Risk of losing your home: Defaulting on payments can lead to foreclosure and losing your home.

Home Equity Loan Requirements

Understanding the requirements for a home equity loan is valuable, especially if you're considering applying. Not knowing what lenders look for can lead to a denial. Common requirements include a good credit score and sufficient home equity, but we’ve outlined other things that lenders consider below.

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    Home equity

    You need sufficient equity in your home, typically at least 15–20%. This is the difference between what your home is worth and what you owe.

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    Credit score

    Lenders usually require a good credit score, generally 680 or higher, to qualify for favorable terms.

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    LTV ratio

    Your loan-to-value ratio should ideally be 80% or less. This ratio compares your loan amount to your home's value.

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    Proof of income

    Lenders need to see proof of stable income, such as pay stubs or tax returns, to ensure you can repay the loan.

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    Proof of insurance

    Homeowners insurance is required to protect the property and the lender’s investment, confirming the home is adequately insured.

How to Get a Home Equity Loan

Knowing how to get a home equity loan can simplify the process and help you secure better terms. Not understanding the steps can lead to delays or rejection. Below, we outline the steps to apply for a home equity loan.

  1. 1
    Assess your home equity

    Calculate the difference between what your home is worth and what you owe. This helps determine if you have enough equity to qualify.

  2. 2
    Check your credit score

    Obtain your credit report to ensure your score meets lender requirements, typically 680 or higher, for favorable terms. You’ll need to obtain your FICO mortgage score directly from myfico.com and pay for an advanced or premium subscription to view the score that lenders consider.

  3. 3
    Determine your LTV ratio

    Ensure your loan-to-value ratio is 80% or less. This ratio affects your loan amount and interest rates.

  4. 4
    Gather financial documents

    Collect pay stubs, tax returns and proof of insurance. Lenders need these to verify your income and the property’s insured status.

  5. 5
    Research lenders

    Compare different lenders to find the best interest rates and terms. Look for reputable lenders with good customer reviews.

  6. 6
    Submit your application

    Complete the lender’s application form and provide all required documents. Be thorough to avoid delays in the approval process.

  7. 7
    Undergo appraisal

    The lender will order an appraisal to determine your home’s current market value. This affects your loan approval and terms.

  8. 8
    Review the loan offer

    Carefully read the loan agreement, including interest rates and repayment terms, to ensure you understand all conditions before signing.

  9. 9
    Close the loan

    Attend the closing meeting to sign the final documents. Pay any closing costs and fees required to finalize the loan.

  10. 10
    Receive your funds

    After closing, the lender will disburse the loan amount, which you can use for your intended expenses.

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READ MORE ON HOME EQUITY LOANS

HELOC vs. Home Equity Loan: What’s the Difference?

A home equity line of credit (HELOC) is another popular option for homeowners looking to tap into their home's equity. Like a home equity loan, a HELOC uses your home as collateral, but there are distinct differences.

For example, while both options provide access to funds, a HELOC has variable interest rates and a draw period, unlike the fixed rates and lump sum of a home equity loan. Below, we compared HELOCs and home equity loans to help you decide which is best for you.

Comparison Areas
Home Equity Loan
HELOC

Interest rate

Fixed interest rate, providing predictable monthly payments and easier budgeting.

Variable interest rates, which can change over time, leading to fluctuating monthly payments.

Term

Fixed term, usually five to 20 years, offering a clear repayment schedule.

Draw period (typically five to 10 years) followed by a repayment period (10–20 years), affecting long-term planning.

Funds disbursement

Lump sum received at closing, ideal for large, one-time expenses.

Funds are available to draw as needed during the draw period, suitable for ongoing expenses or projects.

Interest paid

Interest is paid on the entire loan amount from the beginning.

Interest is paid only on the amount drawn, which can reduce costs if not all funds are used.

Repayment

Fixed monthly payments covering principal and interest, making it easier to manage finances.

Flexible repayment during the draw period, then fixed payments, which can be more complex to manage.

Ask the experts:

What are the pros and cons of a home equity loan or HELOC compared to an unsecured personal loan?

Certified Mortgage Advisor (CMA)

The choice between a home equity loan or HELOC and an unsecured personal loan depends on your individual circumstances, including the purpose of the loan, your credit score, the amount needed, and your comfort level with using your home as collateral. It's important to carefully consider the pros and cons of each option and consult with your lender before making any decisions.

HELOC

Pros:

  • Lower Interest Rates: Home equity loans and HELOCs typically have lower interest rates compared to unsecured personal loans due to the collateral (your home).
  • Potential Tax Deductions: Sometimes, the interest on a home equity loan or HELOC used for home improvements may be tax deductible (consult a tax advisor).
  • Higher Loan Amounts: You can usually borrow larger amounts with a home equity loan or HELOC than unsecured personal loans.
  • Structured Repayment: These loans often have fixed terms with structured repayment plans, making budgeting easier.

Cons:

  • Risk to Homeownership: Your home is used as collateral. If you can't make payments, you risk foreclosure.
  • Upfront Costs: There might be fees involved, such as closing costs, appraisals and application fees.
  • Longer Process: Applying for a home equity loan or HELOC can be more involved and time-consuming compared to a personal loan.
  • Variable Rates (for HELOCs): HELOCs often come with variable interest rates, which could lead to payment fluctuations.

Unsecured Personal Loan

Pros:

  • No Collateral: You don't risk losing your home or property if you can't repay the loan. Quick Approval: Personal loans typically have faster approval processes compared to home equity loans.
  • Fixed Interest Rates: Most personal loans have fixed interest rates, providing payment predictability.
  • Simplicity: The application process is generally simpler and involves less paperwork.

Cons:

  • Higher Interest Rates: Unsecured personal loans tend to have higher interest rates due to the lack of collateral.
  • Lower Loan Limits: You might not be able to borrow as much compared to home equity loans. Shorter Repayment Terms: Personal loans often have shorter repayment terms, which could result in higher monthly payments.
  • Credit Requirements: Your credit score and financial history significantly influence loan approval and interest rates.
Certified Mortgage Advisor (CMA)

Home equity loans and HELOCs offer lower interest rates compared to unsecured personal loans due to the collateral involved (your home). Additionally, the interest on home equity loans may be tax-deductible if used for qualified home improvements, making them potentially more cost-effective. However, the major downside is the risk of foreclosure if you default on payments, as your home serves as collateral. On the other hand, unsecured personal loans don't put your home at risk but often come with higher interest rates and stricter eligibility criteria, as they're not backed by collateral. It ultimately depends on your financial situation and preferences. Again, when it comes to making major financial decisions, it is important to seek professional guidance and conduct a cost-benefit analysis to help you make the best possible decision.

Certified Mortgage Advisor (CMA)

These are the pros and cons:

Pros:

  • The HELOC may have lower interest rates than an unsecured loan (which makes sense since the property is used as collateral, i.e., the security for the loan).

  • The HELOC is used, partially used, or not used, depending upon the borrower's needs, as opposed to an unsecured personal loan, which usually involves a set amount borrowed at the time of the loan origination.

Cons:

  • The property secures the HELOC, and a default under the HELOC could result in a foreclosure on the property.

  • The HELOC may incur additional fees (such as title insurance) that a personal unsecured loan may not.

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FAQ About Home Equity Loans

The nuances of home equity loans may lead homeowners to have many questions about how they work and their benefits. We’ve addressed common questions about it to provide clarity and help you determine the best way forward.

What is a home equity loan, and how does it work?
What is a disadvantage of a home equity loan?
Is a home equity loan the same as a mortgage?
Does a home equity loan have higher interest rates than a mortgage?
How does a home equity loan differ from a HELOC?
Can you get a home equity loan with bad credit?

About Zachary Romeo, CBCA

Zachary Romeo, CBCA headshot

Zachary Romeo is a certified Commercial Banking and Credit Analyst (CBCA), and the Head of Loans and Banking at MoneyGeek. Previously, he led production teams for some of the largest online informational resources in higher education, with over 13 years of experience in editorial production.

Romeo has a bachelor's degree in biological engineering from Cornell University. He geeks out on minimizing personal debt and helping others do the same through people-first content.

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