What is a home equity loan?

What is a home equity loan?

A home equity loan is a type of second mortgage secured by the equity in your home. It offers a set amount at a fixed interest rate, so it’s best for borrowers who know exactly how much money they need. You’ll receive the funds in a lump sum, then make regular monthly repayments amortized over the term of the loan, typically as long as 30 years.

Because your home is the collateral for the loan, the amount you’ll be able to borrow is related to its current market value. The interest rate you receive on a home equity loan (as with other loans) will vary depending on your lender, credit score, income and other factors.

Home equity loans in 2024

While the housing sales have cooled in some areas in recent months due to higher mortgage rates, housing prices have continued to post gains – good news for the net worth of American homeowners. According to the Board of Governors of the Federal Reserve System, U.S. households possessed almost $32 trillion in home equity in the fourth quarter of 2023. That’s a record high, and it means that the vast majority of homeowners are sitting on a huge pile of equity that they can leverage to access cash, including through a home equity loan.

In fact, according to Corelogic, the average homeowner gained about $24,000 in equity in the fourth quarter of 2023, making their ownership stake worth $298,000 at the end of last year.

2023 saw a reversal in the demand for tapping all that equity. As rates jumped, the number of borrowers interested in home equity loans – along with HELOCs, their line-of-credit cousins – dropped in the final months of the year. Particularly hard-hit by their interest rates’ rise above the psychologically important 10 percent mark, HELOC originations declined in 87 percent of the metro areas tracked by ATTOM Data Solutions in Q4 2023. (HE Loans peaked at 9.13 percent.)

As for 2024: The potential for Federal Reserve interest rate cuts could be good news for home equity loans. While the forecast doesn’t call for massive rate drops — for HE Loans, anyway — any reduction in borrowing costs saves prospective borrowers some cash.

What are average home equity loan interest rates?

As of late April 2024, home equity loan rates for the benchmark $30,000 loan are averaging just over 9 percent, within a tight range of 8.5 to 10 percent. While high compared to their average of six percent in 2022, that’s significantly lower than other forms of consumer debt. Credit card rates are lingering above the 20-percent mark, and personal loans can stretch into the 25–35 percent range for borrowers with less-than-perfect credit scores.

How does a home equity loan work?

When you take out a home equity loan, the lender approves you for a loan amount based on the percentage of equity you have in your home and other factors. You’ll receive the loan proceeds in a lump sum, then repay what you borrowed in fixed monthly installments that include principal and interest over a set period. Although terms vary, home equity loans can be repaid over a period as long as 30 years.

Since the loan is secured by your home, the property could be foreclosed upon if you can’t repay what you borrowed: The lender has a right to seize it to recoup its money. If that happens, it can cause serious damage to your credit score, making it harder for you to qualify for future loans.

Home equity loan requirements

Lenders have different requirements for home equity loans, but generally, the standards include:

If you fall short in any of these areas, your chances of approval decrease significantly. Fifty percent of Americans who applied for a loan or financial product since March 2022 have been turned down, including the 3 percent of home equity loans and HELOC applicants, according to Bankrate’s recent credit denials study.

To protect yourself from the risk of foreclosure and its consequences, it’s important to only borrow what you can afford to repay comfortably.Before getting a home equity loan, make sure you understand all of the loan terms, including the interest rates, draw period and any fees and charges.

What should you use a home equity loan for?

You can use the funds from a home equity loan for any purpose. Some of the best reasons to use one include:

• Upgrading your home: Whether you’re looking to remodel your kitchen, add an in-law suite or install solar shingles on your roof, a home equity loan can be a smart way to pay for the enhancements. You’ll be improving your home, which means you get to enjoy living there more; and when you’re ready to sell, the upgrade can potentially make it more attractive (and more valuable) to buyers. Plus, you can qualify for some tax benefits — a deduction on the interest — when you use a loan to invest in the property in this way.
• Consolidating high-interest debt: If you’ve been struggling to pay off debts with high costs like credit cards, a home equity loan can make a big difference in the amount of interest you’re paying. However, if you’re considering this route, there are two important caveats. First, you need to have a real commitment to not build those credit card balances up again. Second, the amount of debt needs to be fairly significant. Credit card balance transfers can be a better option if you’re aiming to pay off less than $10,000.
• Covering large medical bills: Health care can be incredibly expensive, and medical problems often arise unexpectedly. If you or a family member needs a procedure, treatment or long-term care that isn’t fully covered by insurance, a home equity loan could be a good way to handle the costs.

When you should avoid getting a home equity loan

If you’re thinking about using a home equity loan and any of these describe you, think again:

• Covering discretionary spending: You don’t have to go on that pricey vacation for spring break (find something fun to do for a staycation). You also don’t have to host a wedding (go to the courthouse, then dine at a favorite restaurant). While both of those kinds of big expenses can be fun, they are not reasons to hock your home. Save for longer, or find a more affordable way to make them happen.
• Paying for college: You may find lenders who advocate paying college tuition via home equity, but this is a risky move. There is no guarantee that your child is going to graduate, but there is certainly a guarantee that you need to have a home. Look at taking out federal student loans in your child’s name instead: Their interest rates are lower, and they come with benefits like income-based repayment options.
• Paying for a relatively small project: If you only need a small amount of cash – think less than $10,000 – you may be better off looking for other options such as a credit card with a long zero-percent APR period or simply taking longer to set aside some savings.

How much can I borrow with a home equity loan?

To figure out how much you might be able to borrow with a home equity loan, you first need to understand how much home equity you actually have. Your equity is the essentially difference between how much your home is worth and how much you owe on your first mortgage. For example, if your home’s current fair market value is $500,000 and you owe $250,000, you have a 50 percent equity stake.

Most lenders will let you borrow up to 80 percent of your equity stake (some let you go as high as 85 or even 90 percent). However, there’s another factor to consider: How much all your loans amount to or your combined loan-to-value ratio (CLTV). Most home equity loan lenders will cap your total amount of home-secured debt – including your first mortgage – at 80 percent of the home’s market value. So, in that case, you would likely be able to borrow up to $150,000, taking your total mortgage debt to $400,000 (80 percent of $500,000). Bankrate’s home equity calculator can help you estimate your exact borrowing power.

Home equity loan pros and cons

What’s the difference between a home equity loan and a HELOC?

A HELOC – short for home equity line of credit – is also secured by the equity in your home and has similar requirements, but it operates a bit differently. With a HELOC, you can borrow money on an as-needed basis, up to a set limit, typically over a 10-year draw period. During that time, you’ll just have to  make interest-only payments on what you borrow. This means that your payments may be smaller than a home equity loan, which includes both interest and principal. When the draw period on the HELOC ends, you’ll repay what you borrowed and any interest, usually over a repayment term of up to 20 years. Unlike home equity loans, HELOCs have variable interest rates, which means your monthly payments can change.

Other home equity loan alternatives

A home equity loan and a HELOC aren’t your only options for borrowing against your ownership stake. Some other alternatives include:

• Shared equity agreements: Investment companies like Unlock and Hometap offer shared equity agreements, which let homeowners access cash now in exchange for a portion of the home’s value in the future. These arrangements vary, but they all have one upside: You don’t have to make monthly payments, because the money is technically not a loan, but an investment — funds in exchange for a share in your home. However, they all have the same downside: You’re going to make a big payment eventually, and it will likely wind up coming out of the proceeds when you sell the home.
• Cash-out refinance: Another option to convert a portion of your home equity into ready money is through a cash-out refi. Unlike a home equity loan, a cash-out refi replaces your current mortgage with a new one for a higher amount, with you taking the difference between the outstanding balance and the new balance in cash. You’ll need to think carefully about a cash-out refi based on the rate attached to your current mortgage. If you managed to lock in a super-low rate during the pandemic, a cash-out refinance is almost certain to lock you into a significantly higher rate.
• Personal loans: Personal loans can be a cost-effective route if your credit score is in 760-and-above territory. These are unsecured loans – meaning you won’t have to put your house on the line. However, borrowing limits tend to be lower, and the repayment period will be shorter than most home equity loans’.

Home equity loans FAQ

• Does taking out a home equity loan hurt your credit?

  Taking on any form of debt, including a home equity loan, has an impact on your credit score. After you close on a home equity loan, your score might decrease temporarily. Over time, as you continue to make timely payments on the loan, you might see your score recover and even improve, as well.

• How long do you have to repay a home equity loan?

  It varies by lender, but most home equity loans come with repayment periods between five years and 30 years. A longer loan term means you’ll get more affordable monthly payments. That said, you’ll also pay far more in interest. If you can afford the higher monthly payments, selecting a shorter term maximizes overall cost. The ideal is to find a compromise between the two: the maximum manageable payments and the shortest loan term.

• Are there fees associated with home equity loans?

  Fees for home equity loans vary by lender, which makes it very important to compare offers. Some home equity lenders require you to pay an origination fee and other closing costs, typically between 2 percent and 5 percent of the loan balance. You might also pay a home appraisal fee. Once the loan proceeds are disbursed to you, late fees could apply if you remit payment after the monthly due date or grace period (if applicable).

• What can you use a home equity loan for?

  There are no restrictions on how you purpose your home equity loan. The most common uses include debt consolidation for high-interest credit card balances or other loans; home repairs or upgrades; higher education expenses and medical debts. Some choose to use the funds to start a business, purchase an investment property or cover another major purchase.