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Home Equity Loans And How They Work

5-Minute Read
Published on July 23, 2019
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There are plenty of benefits to owning a home. One of the most important? You can build equity and borrow against it in the form of home equity loans. You can then use the money from these loans however 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?

Here’s 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.

You build equity by making your monthly mortgage payments. But you’ll also build equity if your home goes up in value. If you owed $120,000 on your mortgage when your home was worth $150,000, you’d have $30,000 in equity. But if property values in your community were on the rise and this same home was worth $180,000, you’d have $60,000 of equity, without having made any extra payments.

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.

What Are Home Equity Loans?

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

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.

Pros and Cons

There are several benefits to a home equity loan:

  • Your interest rate is usually fixed, so it’s easy to budget for your monthly payments.
  • Interest rates are usually lower than what you’d get with a personal loan.
  • You’ll receive your money in a single payment. You can then use that money however you want.

This doesn’t mean that home equity loans don’t come with potential drawbacks:

  • 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 closings costs, which vary by lender, for a home equity loan.

How Do You Get Approved?

Getting approved for a home equity loan is similar to earning approval for a primary mortgage. Your lender will study your credit reports and pull your credit score. The higher your three-digit 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.

When a Home Equity Loan Makes Sense

One of the greatest benefits of a home equity loan is that 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. If you have a specific project in mind, then, taking out a home equity loan might be one of the most affordable ways to fund it.

Maybe you are burdened with thousands of dollars of high-interest-rate credit card debt. Because your home acts as collateral with a home equity loan, lenders take on less risk than they do when passing out personal loans. Because of this, home equity loans come with 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.

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 master bedroom suite on your home, you can deduct the interest you pay on that loan. That’s because you are using the proceeds from the loan to improve the home.

The Dangers of a Home Equity Loan

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 debts. Depending on how tight your budget is, that extra mortgage payment could prevent you from building your savings or adding to your retirement accounts. This is not a wise financial move. You should also have savings set aside for emergencies, and you should never neglect your retirement fund to help pay for a kitchen remodel.

Home Equity Loan Alternatives

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, better 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 master 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. In a cash-out refinance, 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. You could use this money 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.