How Home Equity Loans Work

Home equity loans can provide access to large amounts of money and be a little easier to qualify for than other types of loans because you're putting up your home as collateral. Suppose your home is valued at $300,000, and your mortgage balance is $225,000. That's $75,000 you can potentially borrow against (although in practice it will be somewhat less, due to loan-to-value ratio). Using your home to guarantee a loan comes with some risks, however.

The Loan-to-Value Ratio

Lenders generally won't let you borrow more than 80% or so of your home’s value, taking into account your original purchase mortgage as well as a potential home equity loan. The percentage of your home's available value is called the loan-to-value (LTV) ratio. When considering a first and a second mortgage, lenders will want to know the combined LTV of both loans. What's an acceptable LTV can vary from lender to lender. Some lenders allow combined LTV ratios as high as 85% or higher, but you will typically pay a higher interest rate.12

For example, consider our $300,000 home in the example above. Assuming a lender accepts a combined LTV of 90%, we would be able to borrow an additional $45,000 on top of our outstanding mortgage loan balance of $225,000. ($225,000 + $45,000 = $270,000, which is 90% of $300,000.)

Home Equity Loans vs. Lines of Credit (HELOCs)

You've most likely heard the terms "home equity loan" and "home equity line of credit" tossed around and sometimes used interchangeably, but they're not the same.

When you get a home equity loan, you will get a lump sum of cash and repay it over time with fixed monthly payments. Your interest rate will be set when you borrow and should remain fixed for the life of the loan.3 Each monthly payment reduces your loan balance and covers some of your interest costs. This is referred to as an "amortizing loan."

With a home equity line of credit (HELOC) you won't get a lump sum of money. Instead, you will get a maximum amount of money that you may borrow—the line of credit—that you can draw from whenever you like. This effectively allows you to borrow multiple times, similar to a credit card. You can make smaller payments in the early years, but at some point the draw period ends and you must start making fully amortizing payments that will eliminate the loan.

A HELOC is a more flexible option, because you always have control over your loan balance—and, by extension, your interest costs. You'll only pay interest on the amount you actually use from your pool of available money.

How To Get a Home Equity Loan

Apply with several lenders and compare their costs, including interest rates. You can get loan estimates from several different sources, including a local loan originator, an online or national broker, or your preferred bank or credit union.

Lenders will check your credit and might require a home appraisal to firmly establish the fair market value of your property and the amount of your equity. Several weeks or more can pass before any money is available to you.

Lenders commonly look for, and base approval decisions on, a few factors:

• You'll most likely have to have at least 15% to 20% equity in your property.
• You should have secure employment—at least as much as possible—and a solid income record even if you've changed jobs occasionally.
• You should have a debt-to-income (DTI) ratio, also referred to as "housing expense ratio," of no more than 36%, although some lenders will consider DTI ratios of up to 50%.

If You Have Poor Credit

Home equity loans can be easier to qualify for if you have bad credit, because lenders have a way to manage their risk when your home is securing the loan. Nevertheless, approval is not guaranteed.

All mortgage loans typically require extensive documentation, and home equity loans are only approved if you can demonstrate an ability to repay. Lenders are required by law to verify your finances, and you'll have to provide proof of income, access to tax records, and more. The same legal requirement doesn't exist for HELOCs, but you're still very likely to be asked for the same kind of information.4

How To Find the Best Home Equity Lender

The best lender for you can depend on your goals and your needs. Some offer good deals for iffy debt-to-income ratios, while others are known for great customer service. Maybe you don't want to pay a lot, so you'd look for a lender with low or no fees. The Consumer Financial Protection Bureau (CFPB) recommends choosing a lender on these kinds of factors as well as loan limits and interest rates.5

Ask your network of friends and family for recommendations with your priorities in mind. Local real estate agents know the loan originators who do the best job for their clients.

Buyer Beware

Be aware of certain red flags that might indicate that a particular lender isn't right for you or might not be reputable:

• The lender changes up the terms of your loan, such as your interest rate, right before closing, under the assumption that you won't back out at that late date.
• The lender insists on rolling an insurance package into your loan. You can usually get your own policy if insurance is required.
• The lender is approving you for payments you really can't afford—and you know you can't afford them. This isn't a cause for celebration but rather a red flag. Be sure you can afford your monthly payments by first crunching the numbers.

If possible, consider waiting a while if your credit score is less than ideal. It can be difficult to get even a home equity loan if your score is below 620, so spend a little time trying to improve your credit score first.6

Alternatives to Home Equity Loans

You do have some other options besides credit cards and personal loans if a home equity loan doesn't seem like the right fit for you.

Cash-Out Refinancing

Cash-out refinancing involves replacing your existing mortgage with one that pays off that mortgage and gives you a little—or a lot of—extra cash besides. You would borrow enough to both pay off your mortgage and give you a lump sum of cash. As with a home equity loan, you'd need sufficient equity, but you'd only have one payment to worry about.

Reverse Mortgages

These mortgages are tailor-made for homeowners age 62 or older, particularly those who have paid off their homes. Although you have a few options for receiving the money, one common approach is to have your lender send you a check each month, representing a small portion of the equity in your home. That gradually depletes your equity, and you'll be charged interest on what you're borrowing during the term of the mortgage. You must remain living in your home, or the entire balance will come due.7

Frequently Asked Questions (FAQs)