How Do Home Equity Loans Work? Understanding Borrowing, Costs and Benefits

A home equity loan lets you borrow against your home's value, using it as collateral to secure a lump sum of cash. Unlike credit cards or personal loans, home equity loans typically offer lower, fixed interest rates because your home guarantees repayment.

If you're wondering how home equity loans work, we'll explain the borrowing process, repayment terms and costs so you can determine if it's right for your financial needs. We'll also cover how much you can borrow and when a home equity loan might make sense for you.

Understanding how home equity loans work is important because they impact your monthly payments and total loan cost. These loans come with specific features that set them apart from other types of borrowing. Here are the main features you should know:

Knowing what you can use a home equity loan for is essential — using it for the wrong reasons can lead to financial strain. For example, using the loan to fund a lavish vacation or buy luxury items might feel rewarding in the short term, but it leaves you with debt tied to your home. If you struggle to make payments, you could risk losing your property. Here are some common ways to put a home equity loan to good use:

Amala, a homeowner, is curious about tapping into her home equity for renovations. Before applying for a loan, she needs to know how to calculate home equity. By following these simple steps, Amala can determine how much equity she has:

Most lenders have other home equity loan requirements besides the home equity and loan-to-value (LTV) ratio. For example, they’ll typically expect a credit score of 620 or higher, though some may require better scores for larger loans.

Lenders also look at your debt-to-income (DTI) ratio, usually requiring it to be below 43%, and your employment history to ensure stable income. Meeting these requirements improves your chances of approval and helps you secure better loan terms.

Building home equity over time can give you more borrowing power and financial flexibility. Whether you plan to sell or tap into a loan, increasing your equity is always smart. Here are some effective ways to boost it:

Lenders typically allow you to borrow up to 80% to 90% of your home’s equity. To find out how much you can borrow, you can do a quick calculation based on your home’s value and mortgage balance.

Just because you can borrow up to $170,000 doesn’t mean you’ll automatically qualify for the full amount. Lenders also consider other factors, such as your credit score, debt-to-income ratio and employment history. For instance, if your debt-to-income ratio is too high or your credit score is below their preferred threshold, they may reduce your loan amount.

Your mortgage rate plays a big role in the cost of your home equity loan. With a fixed interest rate, you'll make consistent monthly payments over the life of the loan, which helps with budgeting. However, the higher your mortgage rate, the more you'll pay in interest over time.

In addition to interest, there are other costs like origination fees and closing costs, ranging from 2% to 5% of the loan amount. These fees are usually rolled into your loan, increasing the total cost you'll need to repay.

Understanding how home equity loans work includes knowing when they’re a smart option and when they could lead to trouble. Borrowing against your home’s equity can be helpful in certain situations, but it’s not always the right choice. Here’s a breakdown of when it’s a good idea — and when it’s not:

A home equity loan might not always be the best fit, especially if you need more flexibility or want to avoid borrowing against your home. There are other financing options worth considering. Here are some home equity loan alternatives and when they might be a better choice:

If you’re still wondering how home equity loans work or if they’re right for you, these common questions might help clarify things. We answered some frequently asked questions about home equity loans, from how they compare to HELOCs to what happens if you can’t repay the loan.