What is a Home Equity Loan? Here’s How it Works

One of the biggest financial benefits of homeownership is building equity—an asset you can tap into when needed. A home equity loan allows you to borrow against that equity, providing funds for major expenses like home renovations, debt consolidation, or investments.

In this Redfin article, we’ll cover what a home equity loan is, how it works, and what you can use the loan for. Whether you own a home in Salt Lake City, UT, or a townhouse in Charlotte, NC, find out if a home equity loan is right for you. 

Key takeaways

• A home equity loan uses the equity in your home as collateral.
• It typically has a fixed interest rate and provides a lump sum of cash.
• Home equity loans can be used for various reasons, like home improvement projects, paying off debts, or investing.

What is a home equity loan?

A home equity loan, sometimes abbreviated as HEL or HELOAN, is a type of loan that uses the equity you have in your home as collateral. It provides a lump sum of money that you repay over time with fixed monthly payments. Because the loan is secured by your home, interest rates are usually lower than personal loans or credit cards.

What is home equity?

Home equity is the portion of your home’s value that you own outright. It’s the amount you’ve paid toward the home – including mortgage payments and your initial down payment. For example, say your home is worth $400,000. Your down payment was $80,000 and you’ve paid an additional $20,000 toward your mortgage. Your home equity would be $100,000

What can a home equity loan be used for?

Home equity loans can be used for a variety of things – not just home renovations. Here are some ways you can use home equity loans:

• Remodel or update your home
• Pay off debts like student loans and credit cards
• Pay college tuition
• Cover wedding costs
• Buy a new car
• Build an emergency fund
• Use funds to invest in stocks

How does a home equity loan work?

With a home equity loan, you’ll have a designated repayment period, anywhere from 5 to 20 years, that you’ll pay back each month in addition to your mortgage payments. The loans have fixed interest rates and are usually lower than personal loans or credit card rates. 

You must have enough equity in your home to serve as collateral for a home equity loan. You can calculate the equity in your home to get an idea of how much home equity you have. Your lender will calculate the loan-to-value ratio (LTV) to determine how much you can borrow. 

How LTV is calculated

• LTV = (Your mortgage balance ÷ Home’s value) × 100
• Most lenders allow you to borrow up to 80-90% LTV.

Additionally, most lenders prefer that you have a credit score above 640. This varies from lender to lender, and some may prefer credit scores in the 700s.

What is a home equity line of credit (HELOC)?

Unlike a loan, a home equity line of credit (HELOC) allows homeowners to borrow money as needed from their home equity. Like a credit card, you can borrow as much or as little as you need, up to a certain amount. The line of credit is open for a set term, often five or 10 years, with a repayment period.

Which option is better?

• Choose a home equity loan if you need a lump sum with predictable payments.
• Choose a HELOC if you need flexible access to funds over time.

What is a home equity agreement (HEA)?

A home equity agreement (HEA) is another way to access your home’s equity – without paying back any debts or monthly payments. An HEA allows you to sell a portion of your home to an investor or company in exchange for cash. The investor is paid back at the time you sell your home or after an agreed-upon number of years. However, HEAs have upfront costs that can be expensive. 

Pros and cons of home equity loans

Like any loan, there are pros and cons to a home equity loan. Let’s take a look at them:

Pros of a home equity loan

Fixed interest rates: Like most mortgage loans, a home equity loan offers a fixed interest rate. That means your repayment schedule will be the same month-to-month.

Flexibility in use: You can use the money how you please, whether it’s to make home improvements or pay off debt

Lump sum of money: You’ll get a lump sum of money upfront, so you’ll be able to use it immediately. 

Lower interest rates: Compared to other loans, like a credit card or personal loan, home equity loans typically have lower interest rates.

Cons of a home equity loan

One-time access to funds: Home equity loans offer one-time access to funds, but if you need more money then you’re out of luck. If you’re unsure how much money you’ll need access to, then a home equity line of credit (HELOC) may be better.

Closing costs: With a home equity loan, you’ll need to pay closing costs which can add up.

Need to have substantial equity: Most lenders require that you have at least 15 to 20% equity in your home in order to qualify for a home equity loan. If you don’t meet those requirements, then you likely can’t get the loan.

Risk of foreclosure: While unlikely, taking out a home equity loan means you’re using the home as collateral. In the event that you can no longer pay your mortgage payments and home equity loan repayments, you risk foreclosure. 

Is a home equity loan right for me?

Before applying for a home equity loan, shop around at several lenders and compare loan terms, interest rates, and conditions. Find out how much equity each lender requires you to have in your home to determine how much you’ll be able to borrow and if that amount is enough.

Make sure you understand the other costs involved in taking out a home equity loan. These include closing costs, application fees, home appraisal fees, attorney’s fees for document preparation, title search, and other legal costs.

FAQs about home equity loans

How much can you borrow with a home equity loan?

Most lenders will let you borrow up to 80% of your home equity, although this can be upwards of 90%. The actual amount will vary depending on how much home equity you have and what your remaining mortgage balance is. 

Are there closing costs on a home equity loan?

Taking out a home equity loan means you’ll need to pay closing costs on the loan. They usually are between 2 – 5% of the loan amount. Sometimes, it can be less than the closing costs on a traditional mortgage or a cash-out refinance, but not always. The closing costs on a home equity loan include appraisal fees, title search fees, and loan origination fees. 

Is interest on a home equity loan tax-deductible?

Yes, you can deduct home equity loan repayments from your taxes, up to $750,000, if filing jointly, and $375,000, if married filing separately. However, if you’re receiving a home equity loan after 2017, you must use the loan to “buy, build, or substantially improve” your home in order to claim the deduction. You’ll need to itemize your taxes in order to receive this benefit. 

Is a home equity loan the same as a second mortgage?

Yes, home equity loans are considered second mortgages. A second mortgage is a loan taken out against the home itself. It may also be called a junior lien.

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