What Is a Home Equity Loan and How Does It Work?

You have equity in your home and you want to access it to complete a renovation project, get over a financial hump, or pull off some other feat that requires a large amount of cash. But there’s only one problem: you love your home and have no desire to sell it. What’s a homeowner to do? 

A viable option is to apply for a home equity loan. But how do they work, do you qualify, and are they the best option? Keep reading to learn the answer to these questions and much more. 

How Home Equity Loans Work 

In a nutshell, a home equity loan is a debt product that’s based on the difference between what you owe on your home and the current market value. Your home will be used as collateral to secure the loan, which functions as a second mortgage and requires you to make monthly payments that include principal and interest. 

How Much Can You Borrow? 

The maximum loan amount is capped at the equity you have in the home. But most lenders will not allow this amount to exceed 80 percent of your home’s value, minus the outstanding balance of your mortgage. 

To illustrate, If your home is worth $190,000 and you owe $140,000 you may be eligible to take out a loan of up to $12,000. To reach this figure, you’d multiply $190,000, which is the value of your home by 80 percent, then subtract the amount you still owe your mortgage, which is $140,000. But if your home is worth $250,000 and you owe $265,000 due to a drop in the market, you wouldn’t qualify for a home equity loan since there’s no equity presence. 

Ultimately, the amount you’re approved for will depend on your credit rating and income. The lender wants to know that you have a positive track record of managing debt obligations. And your ability to make timely payments each month is equally as important. So even if you technically qualify for $12,000 but the lender feels you can only handle a $6,000 loan, that’s the amount they’ll approve you for. 

Are Interest Rates Fixed or Variable? 

The interest rate for home equity loans is fixed, which means you’ll have a set payment amount for the life of the loan. This also makes it easy to work the monthly payment into your budget without fear of a drastic increase out of the blue due to a change in the interest rate.

What Is the Average Loan Term? 

It varies by lender, but you’ll be expected to make timely payments each month for the duration of the loan. And if you want to pay the loan off early to minimize interest, a prepayment penalty may apply. So it’s best to confirm with the lender before signing on the dotted line if you do plan to pay the loan in full before the loan term is up. 

How Are Loan Proceeds Disbursed? 

You will receive the loan proceeds in a lump sum once the paperwork is finalized and processed by the lender. 

Should You Apply for a Home Equity Loan?

Before deciding if a home equity loan is right for you, there are some benefits and drawbacks you should consider:

Benefits of Home Equity Loan

  • Lower interest rates. Compared to credit cards and some traditional personal loans, the interest rate you’ll find on home equity loans is lower. 
  • Less stringent qualification criteria than other loans. Because some lenders will accept a credit score as low as 620, you may qualify for a hefty loan amount with a decent interest rate, which beats bad credit installment loans. 
  • Rapid closing period. You’ll know in a relatively short period if you’re approved, and the process to finalize the loan is simple. 
  • Positive payment history. Assuming you make timely payments on the loan each month, your credit score could improve as payment history accounts for 35 percent. 

Drawbacks of Home Equity Loans

  • Dangers when you default. If you hit a rough financial patch and are unable to make your monthly payments on time, your home could be at risk since it serves as collateral for the loan. This means the bank has rights to your home and can seize it to pay off the loan if you default on the agreement. 
  • Minimum loan requirement- some banks have minimum thresholds on the amount you can borrow. And if you don’t quite have enough equity in your home, you will more than likely be turned away. 
  • Built-in interest- Unlike a home equity line of credit (HELOC), which only assesses interest on the funds you draw, home equity loans have built-in interest on the total amount since you receive the loan proceeds at once. And it doesn’t matter if you don’t use all the funds. You’ll continue to pay interest until the loan is paid in full. 

How to Qualify for a Home Equity Loan 

Wondering if you qualify for a home equity loan? Before applying with a lender, you should now that most want you to meet the following criteria:

  • Equity in your home of at least 20 percent 
  • A steady, verifiable source of income to make monthly payments on your loan 
  • A debt-to-income ratio that does not exceed 43 percent (which means the sum of your loan payment and other monthly debts cannot be greater than 43 percent of your monthly earnings before taxes)
  • A FICO credit score of at least 620

Don’t quite fit the bill? It doesn’t hurt to reach out to lenders you’re considering as some may have more relaxed qualification criteria or be willing to approve you off the strength of a strong relationship with their financial institution.

Other Options 

What if you don’t quite qualify for a home equity loan? Or maybe you don’t feel like it’s a good fit? Here are some other options to consider: 

Personal Loan

Personal loans come in all shapes in sizes. If credit challenges are preventing you from qualifying for a home equity loan, you may be able to get approved for a loan, but the interest rate will be higher due to the increased risk you pose. Personal loans can be both secured and unsecured, and the loan amounts and payment terms vary by lender. 

Cash-Out Refinance

A cash-out refinance swaps your current mortgage with a new one that includes the loan proceeds. When you close on the loan, you’ll receive the overage between what you owe and what remains to spend at your disposal. If you go this route, keep in mind that even if the rate is low, you’ll pay interest on the “cash-out” amount over the life of the mortgage. 

Home Equity Line of Credit

This debt product allows you to only borrow the amount you need, and you will only pay interest on the portion of the funds you draw. But keep in mind that the monthly payments will fluctuate depending on how much you borrow and when you borrow it. Furthermore, interest rates on HELOCs are variable, so your monthly payment could increase drastically over time. 

Home Improvement Loan

These loans are not secured by collateral and do not require that you have a set amount of equity in your home. As long as you meet the minimum income and credit criteria set forth by the lender, you’re good to go. Even better, you’re free to use the loan proceeds how you please. 

What Happens If You Sell Your Home? 

If you sell your home before the balance of the home equity loan is paid in full, you will have to deduct the amount you still owe from the proceeds received during the transaction. But what if you’re taking a loss? Unfortunately, you’ll still be on the hook for the outstanding balance and could encounter hiccups when attempting to close as the loan is a lien on the property and can’t be released without payment in full. 

The Bottom Line

A home equity loan may be a good option if you’re looking to access the equity in your home. But as with any loan product, be sure to read the fine print before signing on the dotted line. That way, you won’t be in for any surprises later on down the line.