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Home Equity Loans And How They Work

5-Minute Read
Published on December 15, 2020

There are plenty of benefits to owning a home. One of the most important is building equity and borrowing against it in the form of home equity loans.

You can use the money from these loans how ever you want. You could pay for a major kitchen remodel, pay off your high-interest-rate credit card debt or help cover the cost of your children’s college tuition.

But what exactly are home equity loans? How do you qualify for them, and how do they work?

Let’s take a look at these important tools.

What Is Equity?

To qualify for a home equity loan, you’ll need to have built up enough equity in your home. Equity is the difference between what your home is worth today and what you owe on your mortgage. If you owe $150,000 on your mortgage and your home is worth $200,000, you have $50,000 worth of equity.

What Is A Home Equity Loan?

Home equity loans are second mortgage loans that you pay off with monthly payments, just as you do with your primary mortgage.

When you apply for a home equity loan, your lender will usually approve you for a loan equal to a portion of your equity, not the entire amount. If you have $80,000 of equity, for instance, a lender might approve you for a maximum home equity loan of $70,000.

Once you’re approved for a home equity loan, you’ll receive your money in a single lump payment. You then pay the loan back with interest over a set period of years.

The number of years this will take depends on the loan term you agreed to when taking out your home equity loan. Your monthly payment will depend on the amount you borrowed and your interest rate.

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Pros And Cons Of Home Equity Loans

Home equity loans aren’t for everyone. Using home equity for the right reasons can be a smart and savvy way to borrow money. But being smart about borrowing from your home equity is critical. Here are some of the pros and cons of home equity loans.


Of course, homeowners lean on home equity loans for good reason. You’re more likely to enjoy lower, fixed interest rates than with a personal loan. Plus, you receive the loan payment in a lump sum, allowing you to immediately get started on that home improvement project, or pay off your credit card debt.


While a home equity loan can help you improve your home or meet other financial goals, it does come with some possible pitfalls. Your home acts as collateral for such a loan. If you can’t pay back your loan, your lender could take your home through the foreclosure process.

A home equity loan will also add to your monthly debt. Depending on how tight your budget is, that second monthly mortgage payment could prevent you from building your savings or adding to your retirement accounts.

Be sure to weigh your options to make sure a home equity loan is financially worth it.



● Fixed interest rates make it easy to budget for your monthly payments.

● Lower interest rates than a personal loan or credit card make it a wiser alternative.

● Lump sum payments allow you to use that money however you want.

● Tax deductions: You can deduct the interest on a home equity loan if you’re using the money for home improvement.

● Your home is your collateral: If you fall behind on your payments, you could lose it.

● They’re not free: You’ll have to pay borrowing costs, which vary by lender. When comparing interest rates, be sure to factor in other annual fees.

When A Home Equity Loan Makes Sense

Home equity loans are so attractive because you can use the money from them for whatever you want.

If you need to update a kitchen that was last renovated in the 1970s, you can use the cash from a home equity loan to pay your contractor. If you want to help your children cover their college tuition, you can use a home equity loan for this, too. Maybe you're burdened with thousands of dollars of high-interest-rate credit card debt. A home equity loan will likely have lower interest rates, and for good reason.

Home equity loans are attractive to lenders because your home acts as collateral, making it a lower-risk loan compared to personal loans.

Lower risk means lower interest rates. It might make financial sense to swap home equity debt, with its lower interest rates, with your more expensive credit card debt.

How To Get Approved For A Home Equity Loan

Getting approved for a home equity loan is similar to approval for a primary mortgage. Your lender will study your credit reports and pull your credit score. The higher your credit score, the more likely you’ll be approved for your home equity loan. A higher credit score usually means a lower interest rate, too.

Your lender will also look at your existing monthly payments – including what you pay on your primary mortgage loan – and your gross monthly income to determine if you can afford a new home equity loan payment.

Lenders vary, but most want your total monthly debts, including any mortgage payments, to equal no more than 43% of your gross monthly income. In short, you should plan to meet the following requirements:

Can You Still Deduct The Interest You Pay On Home Equity Loans?

Before the Tax Cuts and Jobs Act of 2017 became law, homeowners could deduct on their taxes the interest they paid on home equity loans no matter how they used the money. That has changed.

According to the IRS, you can now only deduct the interest on home equity loans if you use the money to substantially improve the home that secures the loan.

This means that you can’t deduct the interest if you use a home equity loan to pay off credit card debt or cover a child’s college tuition.

If you use your home equity loan to build a new primary bedroom suite on your home, you can deduct the interest you pay on that loan. That’s because you’re using the proceeds from the loan to improve the home.

Home Equity Loan Alternatives

If you’re not sold on the home equity loan option, there may be a better financial fit for your circumstances. Here are just a couple alternatives to a home equity loan.

Home Equity Lines Of Credit

Home equity loans aren’t the only way to borrow against the equity in your home. You can also apply for a product known as a home equity line of credit.

A home equity line of credit, commonly known as a HELOC, acts more like a credit card than a loan, with a credit limit based on the equity in your home. With a HELOC, you only pay back what you actually borrow.

Say you get approved for a HELOC of $50,000. If you spend $20,000 to add a primary bedroom to your home, you’d pay back that $20,000 – not the full $50,000 – in monthly payments with interest.

While a home equity loan is good for homeowners who have a specific plan in mind for the money they’ll receive, a HELOC is a good choice for those who want access to a line of credit for expenses that pop up over time.

Cash-Out Refinance

You might also consider a cash-out refinance. With this option, you refinance your existing mortgage loan into one that has a balance higher than what you currently owe. You’d then receive this extra money in a lump sum to pay for whatever you want.

Say you owe $150,000 on your mortgage. You can refinance that loan into a new one with a balance of $180,000. You’d then receive the extra $30,000 as a single payment.

One of the benefits of a cash-out refinance is that you’re still left with just one mortgage payment a month. Depending on the strength of your credit, you might also qualify for a lower interest rate.

A drawback? A cash-out refinance can be expensive. You’ll have to pay your lender closing costs. Depending on the amount of equity in your home, a cash-out refinance might not work. If you owe $150,000 on your mortgage and your home is only worth $160,000, a cash-out refinance probably isn’t worth it.

Talk to a Home Loan Expert today to see if a cash-out refinance is right for you by calling (800) 785-4788 or applying online.

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