What Is a Home Equity Loan? Here’s What You Should Know

Home equity is the difference between what your home is worth and what you owe your mortgage lender. When you have equity in your home, you can borrow against it using a home equity loan (HELOAN). These loans offer flexible financing with low interest rates and extended repayment terms. However, they also have drawbacks and can be risky if your financial situation is uncertain. 

We’ll cover the pros, cons, and qualifying requirements for home equity loans, and when to consider other loan options.

What is a home equity loan?

A home equity loan, also known as a second mortgage, allows you to borrow against your home equity by using your home as collateral — it provides a lump sum of cash that you repay over several years with interest. But if you fall behind on payments, you could lose your home to foreclosure.

How does a home equity loan work?

A HELOAN uses your home as collateral, which means the home equity lender will register a lien on your home until you repay your loan in full. 

The application process is similar to applying for a mortgage. Lenders require a credit check, title approval, and home appraisal, and you'll usually need to pay closing costs. It may take between two weeks and two months to fund the loan. 

Unlike a home equity line of credit (HELOC), a home equity loan provides a lump sum of cash. You typically repay the loan in fixed monthly payments with interest over five to 30 years. Though rare, some lenders also offer interest-only home equity loans with a balloon payment due at the end of the term. 

If you miss payments on your home equity loan and go into default, the lender can take your home through foreclosure. 

How much can you borrow with a home equity loan?

Home equity lenders typically allow you to borrow up to 80% or 85% of the equity in your home in total, accounting for your current mortgage and the home equity loan. However, a few may allow a loan-to-value ratio (LTV) of up to 90% or even 100%.

Example: If the lender allows HELOANS up to 85% and your home is worth $500,000, this is how you’d calculate the maximum amount (assuming you have $300,000 left on your first mortgage):

1. Multiply the percentage the lender allows by your home’s current value to determine how much equity you can borrow in total: 
   85% x $500,000 = $425,000
2. Subtract your current mortgage from that amount: 
   $425,000 - $300,000 = $125,000

In this case, you can borrow up to $425,000 across all loans — which means you could potentially get a home equity loan for up to $125,000.

That said, each lender sets its own loan limits. Some credit unions and online lenders may offer home equity loans with a higher loan-to-value ratio if you’re willing to pay a higher APR. Note that if you take out a large amount of equity, you increase the risk of owing more than what your home is worth if property values fall.

What are home equity loans typically used for?

Home equity loans are flexible and can be used for almost anything you'd like. Some common ways people use home equity loans include:

• Home improvements: A home equity loan can be a smart way to finance a home renovation, especially if the project increases your home’s value, resulting in an increase in equity and potential future profits. Interest on home equity loan debt may also be tax-deductible if you itemize on your taxes and use the loan to buy, build, or substantially improve the property. 
• Debt consolidation: “By consolidating high-interest credit card debt into a lower-interest home equity loan, you drastically reduce the interest you pay each month. The move is to then redirect that exact monthly savings back into a wealth-building asset,” says Terrance Amen, founder of Family Business Circle. But pay attention to your repayment timeline and upfront fees before pursuing this option. 
• Medical bills: You can use a home equity loan to pay for a costly medical procedure or treatment not covered by insurance, such as IVF. 
• Educational expenses: While home equity loans can cover educational expenses, it’s often best to exhaust funding from federal student loans and grants first and compare unsecured private student loan rates before putting your home at risk. 
• Starting a business: Some entrepreneurs use home equity loans to fund business ventures, but it’s typically better to get a small business loan rather than using your home as collateral to borrow for a business that may not succeed. 

It’s generally not advisable to use a home equity loan for unnecessary or routine expenses. 

What are home equity loan eligibility requirements?

Home equity loan requirements vary by lender, but most lenders consider the following criteria when evaluating applicants:

• Credit score: Most lenders require a minimum credit score in the mid-600s, though it may be possible to qualify with a lower score by meeting other financial criteria. “If a homeowner has a fair credit score but high equity, they often have more leverage with a home equity loan than they would with a personal loan,” says Amen. 
• Debt-to-income (DTI) ratio: Lenders look at your debt-to-income ratio to see if you can afford additional debt. Many lenders prefer a DTI under 43%, but some allow a maximum DTI of 50%. To calculate your DTI, divide your total monthly minimum debt payments by your monthly pre-tax income and multiply by 100. 
• Income: You’ll need to show proof of sufficient income to make monthly payments for the loan. 
• Payment history: Lenders look for applicants who consistently pay debts on time, as they're considered to have a lower default risk. 
• Home equity: While requirements vary between lenders and loan products, you typically must have at least 15-20% equity in your home to qualify for a home equity loan.  

Pros and cons of home equity loans

Details on the pros

• Large loan amounts: You may have a high loan limit depending on how much equity you have in your home. 
• Fixed monthly payments: Home equity loans typically have fixed interest rates, which means monthly payments stay the same each month. That makes budgeting for repayment easier. 
• Long repayment terms: Some home equity loans have repayment terms up to 30 years, which is a key advantage compared with unsecured loans. Many personal loan lenders cap repayment terms at 7 years, though some offer longer terms to qualified borrowers. 
• Interest may be tax-deductible: If you use the funds for home improvements, home equity loan interest may be tax-deductible up to IRS limits if you itemize. 
• Lower rates than most unsecured loans: Home equity loans typically have lower interest rates than unsecured loans like personal loans and credit cards. 

Details on the cons

• Longer funding timeline: Because home equity loans usually require a home appraisal, it typically takes at least 2 weeks to get your cash. Personal loans, on the other hand, may offer funding as soon as the same day, which makes them better for emergency expenses. 
• High upfront costs: Closing costs for home equity loans can be substantial, typically ranging from 2% to 5% of the loan amount. 
• May exacerbate debt woes: Taking out a home equity loan to consolidate debt won’t fix the underlying issue if you don’t also change your spending habits. “Equity loans cost less than most credit cards, so sometimes it is tempting to do that. I caution you, that is a slippery slope,” says A’Costa. The CFPB recommends discussing your options with a credit counselor before applying for a home equity loan to consolidate debt. 
• Risk of foreclosure: If you fall behind on your home equity loan payments, the lender could foreclose on your home. Even if the monthly payment seems manageable now, your financial situation could change. 
• Risk of underwater mortgage: In the event of an economic downturn, property values could decline, and you could end up owing more than your home is worth. That puts you in a difficult position if you need to refinance or sell your home.

Home equity loan vs. HELOC: What’s the difference?

A home equity line of credit (HELOC) is another way to borrow against the equity in your home. However, instead of borrowing a lump sum, you get access to a line of credit you can draw from as needed. 

“It is like having a credit card that you use only when you need to and for how much you wish to spend,” says Lorin A’Costa, Strategic Financing Advisor at Real Estate Bees. “You will pay interest on just the amount you use, and the rest will sit and be available when or if needed.”

Some HELOC lenders offer a 100% digital application process with no appraisal requirement and fast funding. There are also some key differences in the interest rate type and repayment structure. The table below shows how a HELOC compares to a home equity loan.