African American Couple Reading Documents In Renovated Kitchen

Home Equity Loans: What Are They And How Do They Work?

7-Minute Read
Published on June 21, 2022
Share:

Owning a home has plenty of benefits. 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 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?

Although Rocket Mortgage® doesn’t offer home equity loans at this time, we want you to understand all of your options. Let’s take a look at how home equity loans work, their requirements and how to get one.

Apply for a Mortgage with Quicken Loans®

Apply online for expert recommendations with real interest rates and payments.

Start Your Application

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, a lender might approve you for a maximum home equity loan of $70,000, for example.

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

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 in equity.

The 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.

Advantages

Homeowners tend to 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.

Disadvantages

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.

At A Glance

Pros

Cons

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 fees.

When A Home Equity Loan Makes Sense

Home equity loans can be attractive to homeowners because you can use the money from your lender 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 for a lender compared to personal loans.

Lower risk means lower interest rates. It might make financial sense to swap home equity debt – and 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 also usually means a lower interest rate.

Your lender will 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 would prefer 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:

Find out which loan option is right for you.

See rates, requirements and benefits.

Explore My Loan Options

Home Equity Loan Alternatives

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

HELOC Vs. Home Equity Loan

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 (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. They have a draw period and a repayment period.

The draw period lasts for several years at the beginning of the loan, during which you’re only required to pay interest on the money you borrow. You can also put the money you borrowed back in during the draw period to take it out again for other purposes.

Once the HELOC enters the repayment phase, you can’t borrow anymore. Instead, the principal and interest are paid back over the remainder of the term on any existing balance.

Let’s 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 with a specific plan in mind for the money they’ll receive, a HELOC is a better choice if you want access to a line of credit for expenses that pop up over time. Rocket Mortgage doesn’t offer HELOCs at this time.

Cash-Out Refinance Vs. Home Equity Loan

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 you currently owe. You’d then receive this extra money in a lump sum to pay for whatever you want.

If, for example, 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. Because a cash-out refinance is based on your primary mortgage, a lower rate is common relative to home equity loans or HELOCs that are tied to a secondary lien and riskier for lenders.

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.

Home Equity Loan FAQs

Home equity loans aren’t for everyone, and you may have more questions when deciding if it’s the right option for you. Let’s take a look at a few commonly asked questions pertaining to home equity loans.

Can I get a home equity loan with bad credit?

As mentioned above, in order for you to get a home equity loan, lenders like to see a credit score of at least 620.

How long does it take to get a home equity loan?

It can take anywhere from 2 – 4 weeks to get a home equity loan. This all depends on where you get the loan, how quickly you can get approved and whether you’ve completed all the right documentation.

Can I still deduct the interest I 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 now 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, for example.

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.

The Bottom Line

If you’re debating about getting a home equity loan, make sure you not only understand the requirements but also know your interest rate and new monthly payment. Speaking with your real estate agent or mortgage lender can put you on the right path when deciding if a home equity loan is right for you. If you’re looking for more information on other loans, check out the Rocket Mortgage® Loan Types Resources. If you decide a cash-out refinance makes more sense for you, you can get approved online or give one of our Home Loan Experts a call at (833) 230-4553.

Apply Online with Rocket Mortgage

Get approved with Rocket Mortgage® – and do it all online. You can get a real, customizable mortgage solution based on your unique financial situation.

Apply Online

See What You Qualify For

Andrew Dehan Headshot

Andrew Dehan

Andrew Dehan is a professional writer who writes about real estate and homeownership. He is also a published poet, musician and nature-lover. He lives in metro Detroit with his wife, daughter and dogs.