Home Equity Loans: What They Are And How To Get One
Owning a home has plenty of benefits. One of the most helpful is the opportunity to build equity. Homeowners with enough equity can tap into these funds in the form of a home equity loan to cover a wide range of expenses.
Knowing how a home equity loan works and how to apply for one can help you access your home equity and put it to use.
What Is A Home Equity Loan?
A home equity loan, sometimes called a second mortgage, lets you borrow against the available equity in your home. You receive a lump sum payment and then repay the loan in fixed monthly installments over a period of time, usually ranging from 3 – 10 years.
Keep in mind, your home serves as the collateral for the loan. As you’ll see, that allows lenders to offer lower interest rates than you could typically get with a personal loan. On the other hand, if you fail to make your payments, your lender has the right to foreclose on your home.
How Does A Home Equity Loan Work?
When you take out a home equity loan, you agree to borrow a certain amount and pay it back at a fixed interest rate over a certain number of years. The interest rate and period of time will affect the size of your monthly payment and the amount of interest that you’ll pay over the life of the loan.
Let's assume that you borrow $10,000 at a 7% interest rate. In this case, your monthly payments and the amount you’ll pay in interest will follow the table below.
Repayment Schedules For A $10,000 Home Equity Loan With 7% Interest
Loan Term |
Monthly Payment |
Total Interest Paid |
3 years |
$309 |
$1,116 |
5 years |
$198 |
$1,881 |
7 years |
$151 |
$2,678 |
10 years |
$116 |
$3,933 |
As you can see, the longer the term, the lower the monthly payment, but the more you’ll pay in interest.
What Are The Interest Rates For A Home Equity Loan?
Because a home equity loan uses your home as collateral, the interest rates for home equity loans are usually comparable to the interest rate that you’d pay for a home mortgage loan. This can make home equity loans a more affordable option compared to unsecured loans like credit cards and personal loans which often have higher interest rates.
Normally, your interest rates will depend on:
- The prime rate: The prime rate is the cost to lenders to borrow from the federal government. This rate serves as a benchmark for lenders. When the rate changes, home equity loan interest rates tend to go up or down accordingly.
- Your credit score and credit history: Lenders will want to look at your credit score and credit history to see how much debt you have and your track record in paying it back.
- The length of your loan term: Lenders tend to offer lower interest rates to shorter loan terms.
As an example, here’s a breakdown of how much you’d pay each month and how much you’d pay in interest for a $10,000 home equity loan with different interest rates and repayment schedules.
$10,000 Home Equity Loan With A 5-Year Repayment Schedule
Interest Rate |
Monthly Payment |
Total Interest Paid |
4% |
$184 |
$1,051 |
6% |
$193 |
$1,600 |
8% |
$203 |
$2,166 |
10% |
$212 |
$2,748 |
$10,000 Home Equity Loan With A 10-Year Repayment Schedule
Interest Rate |
Monthly Payment |
Total Interest Paid |
4% |
$101 |
$2,149 |
6% |
$111 |
$3,322 |
8% |
$121 |
$4,559 |
10% |
$132 |
$5,858 |
One thing you may notice is that even with the same interest rate, the longer you have a loan, the more it will cost you in interest.
Let’s take an 8% interest loan as an example. You’d pay $2,166 in total interest with a 5-year repayment schedule. Over 10 years, you might expect to pay $4,332, which would be double the amount of interest paid. But, in fact, the interest paid for the 10-year loan is actually $4,559, or $227 more over the life of the loan.
Get a Home Equity Loan online.
How Much Can You Borrow With A Home Equity Loan?
As a homeowner, you build home equity by making mortgage payments to reduce your principal mortgage balance. Your home equity also increases as your home’s appraised value increases over time.
To calculate your home equity, you simply subtract your current mortgage balance from the current value of your home. However, most lenders will not allow you to borrow against all of your home equity. Instead, they will allow you to borrow up to a certain percentage of your home’s appraised value, usually 75% – 85%. This is usually referred to as your home’s loan-to-value ratio (LTV).
So the formula you’d use is:
(Current value of your home ✕ LTV) – Current mortgage balance = Available home equity
Home Equity Loan Calculation Example
Let’s say you own a home that is currently valued at $300,000, and your current mortgage balance is $215,000.
Your lender is willing to lend you up to 80% of your home’s value, so that would be $300,000 * 0.80, or $240,000. In this case, you’d be able to borrow $240,000 minus your mortgage balance of $215,000, which equals $25,000.
What Are The Other Home Equity Loan Requirements?
In addition to having enough equity, you’ll need to meet the requirements of your lender to get a home equity loan finalized. Below you’ll find a breakdown of the general requirements:
- Debt-to-income ratio: In general, lenders prefer to work with borrowers who have a debt-to-income ratio (DTI) of no more than 45%. A higher DTI ratio indicates you might struggle to squeeze another payment into your monthly budget.
- Credit score: A higher credit score may help you tap into a higher loan amount or lower interest rate. Ideally, you should have a credit score of at least 620.
Of course, every lender has unique requirements. Before applying with a particular lender for a home equity loan, take a look at their requirements to confirm your application has a good chance of approval.
What Are Some Reasons To Use A Home Equity Loan?
When you borrow money using a home equity loan, you are allowed to use the money however you see fit, as long as you make your payments on time and in full. However, some options are more popular than others. Let’s look at some of the top uses.
Consolidate Debt
Because home equity loans have lower interest rates than credit cards or personal loans, it may allow borrowers to consolidate their debts into a single payment at a lower interest rate. As an added bonus, some lenders may even offer a lower interest rate if the money is paid directly to the credit card company or other creditor.
Home Improvements And Repairs
Many homeowners use home equity loans for home repairs and renovations. This can help improve the value of their home in the future. Also, if you use your home equity loan for home improvements, the interest may be deductible on your federal taxes.
Invest In Real Estate
If a homeowner is looking to invest in a second home or rental property, using a home equity loan to help cover the upfront costs can be a smart move, especially if the potential income from the investment can cover the costs of the loan in the future. However, as with all investments, there is potential for risk, which could cost you your home.
How To Apply For A Home Equity Loan?
If you’re ready to get a home equity loan, understanding the process can lead to a smooth experience.
1. Evaluate Your Home Equity
Look at your current home equity to see whether the potential loan will meet your needs. If you cannot borrow enough to cover the major expense looming on your horizon, then you might need to find a different loan option.
2. Check Your Credit Score And Credit History
Next, see where your credit score stands. You can find out with a simple check. Remember, you can review your credit report annually, for free. If you don’t like what you see, take a closer look at your credit history. Any mistakes on your credit report can be removed, which might have a positive impact on your credit score.
Before you move forward with your application, be honest about your credit score. If you have a bad credit score, you might struggle to find a lender willing to work with you. Depending on the situation, it might be a good idea to work on building your credit before diving into your home equity loan application.
3. Gather Your Financial Paperwork
Because a home equity loan is a type of mortgage, the documents you provide to the lender might feel similar to the documents you provided during the original mortgage process.
Here’s a quick look at some of the documentation you may need to provide to your lender:
- Recent pay stubs or other proof of income and employment
- W-2 forms or tax returns for the last 2 years
- Recent bank statements
- Identity documentation, such as a driver’s license
- Social Security number
You may need to provide some of these when you submit your initial application and others later during the underwriting process, but having them ready before you start can help speed up the application process.
4. Compare Home Equity Loan Lenders
As with all major financial decisions, you should shop around before applying to work with a particular home equity loan lender. If you don’t shop around, you could easily overpay.
As you shop around, look for a lender that offers competitive interest rates and fees. Additionally, you’ll want to choose a lender with a good reputation.
5. Apply For A Home Equity Loan
When you find a lender you’re comfortable with, it’s time to apply for the loan. The initial application will ask questions about your financial situation, employment situation and home value.
After receiving your application, the lender will likely conduct some due diligence. For example, you might be required to provide documentation for your income through pay stubs or bank statements.
6. Have Your Home Appraised
Depending on the type of home equity loan, many lenders will conduct home appraisal to confirm its current value. While the lender orders the appraisal, as the borrower, you’ll be responsible for paying for the appraisal.
For home equity loans, many lenders will use a desktop appraisal, which is based on the price of comparable homes in your area. If your lender requests a full appraisal, where the appraiser looks at your home inside and out, you may be able to improve your appraised value by cleaning your home and taking steps to improve its curb appeal.
Remember, the higher the appraised value of your home, the more you’ll be able to borrow. If your appraisal comes back lower than you expected, it may affect your ability to qualify for the loan you need.
7. Close On Your Home Equity Loan
Once your lender has appraised your home and approved your loan, the last step is closing. You’ll meet with your lender to sign any necessary documents and to either receive your loan. You may also be required to pay some or all of your closing costs at closing, so check with your lender to know what’s expected.
Alternatives To A Home Equity Loan
A home equity loan isn’t the only way to get access to the funds you need. There are other options homeowners can explore.
Cash-Out Refinance
A cash-out refinance involves replacing your existing mortgage with one that has a higher loan balance. Like a home equity loan, you’ll receive the funds as a lump sum to use as you see fit, but you’ll only have one mortgage payment to keep up with.
Pros Of A Cash-Out Refinance
- Potentially lower interest rates: Because a cash-out refinance is based on your primary mortgage, a lower rate is common relative to home equity loans
- Only one monthly payment: Instead of having to make two separate payments each month, you only have to make a single monthly payment.
Cons Of A Cash-Out Refinance
- Higher closing costs: Because your closing costs are a percentage of the total amount you borrow, the closing costs for a cash-out refinance will be higher compared to a home equity loan.
- May take longer to apply: Applying for a new mortgage is often a more involved process which may add to the time it takes to complete the application and underwriting process.
- A new mortgage rate: If you got your mortgage during a time of low interest rates, you may want to keep your old rate. A cash-out refinance means getting a new rate.
Home Equity Line Of Credit (HELOC)
A home equity line of credit (HELOC) also gives homeowners access to their home equity. HELOCs are generally more flexible than home equity loans, but you’ll still be taking on a second mortgage payment.
These types of loans act more like a credit card than a loan, with a credit limit based on the equity in your home. HELOCs have a draw period and a repayment period. Both of these periods last for a predetermined amount of time.
Pros Of A HELOC
- Greater flexibility: With a HELOC, you only pay back what you actually borrow. This can allow greater flexibility in terms of making payments and repaying the loan.
- Longer repayment period: You usually only have to make minimum payments during the draw period. Then your repayment schedule is locked in during the repayment period. This can give you more time to repay the amount you borrow.
Cons Of A HELOC
- Higher interest rates: Because a HELOC is considered riskier than a home equity loan, the interest rates will usually be slightly higher by comparison.
- Potential for higher interest rates: HELOCs are usually variable rate loans, which means the interest rate can go up or down over time. That means your interest rate could increase over the life of the loan, making it harder to budget for your monthly payments.
Personal Loan
Like a home equity loan, a personal loan allows you to borrow a lump sum of money and repay it in fixed-monthly installments. However, a personal loan is unsecured, meaning that there’s no collateral or home equity required.
In general, personal loans come with higher interest rates than home equity loans due to the lack of collateral. While a higher interest rate isn’t ideal, personal loans may provide more peace of mind because your home isn’t on the line.
Home Equity Loan FAQs
You have questions about home equity loans. We have answers.
How much are closing costs on a home equity loan?
Closing costs on a home equity loan are usually equal to 2% – 6% of the value of the loan. However, instead of having to pay them at closing, your lender may be able to fold all or some of the costs into your loan.
How long does it take to get a home equity loan?
Once you’ve submitted an application, it usually takes 2 – 4 weeks to get a home equity loan. This may vary depending on your lender and how quickly you can provide your lender with the documentation they need to review and approve your application.
Can I get a home equity loan with bad credit?
If your credit score is below 620, you may have a hard time getting approved for a home equity loan. If you do get approved, your lender may also charge a higher interest rate.
If you have bad credit, consider improving your score before applying for a home equity loan.
If I have a mortgage, can I get a home equity loan with a different lender?
Yes. You can take out a home equity loan with a different lender than the one that holds your first mortgage. Just keep in mind that you’ll need to make a separate payment to each lender.
The Bottom Line
A home equity loan might be the right solution for your financial situation. If you’ve decided that a home equity loan is the right move for you, get started online today.
Sarah Sharkey
Sarah Sharkey is a personal finance writer who enjoys diving into the details to help readers make savvy financial decisions. She’s covered mortgages, money management, insurance, budgeting, and more. She lives in Florida with her husband and dog. When she's not writing, she's outside exploring the coast. You can connect with her on LinkedIn.