What Is a Home Equity Loan?

Key takeaways: 

• A home equity loan, also known as a second mortgage, is a type of borrower debt.
• With a home equity loan, homeowners can borrow against the equity in their home.
• Funds from a home equity loan can be used to pay for a variety of expenses, including home improvement, education, and emergencies. 

With inflation and the rising costs of goods and services, many people are looking for alternative ways to pay for large purchases and life expenses. One common financing option available to homeowners is a home equity loan. 

A home equity loan lets you borrow money against the equity in your home. If you’re a homeowner looking to finance a major life purchase, learn more about how home equity loans work and what the requirements are. That way, you can be sure it’s the right financial move for you.

Home equity loan definition

Home equity loans are a type of credit homeowners can take out if they qualify. They are also referred to as second mortgages, equity loans, and home equity installment loans. 

If approved, a homeowner can take out a home equity loan to borrow money using the equity in their home. Typically, borrowers who take out a home equity loan already have a home loan or mortgage on their property, which is why it’s sometimes called a second mortgage.

Because a home equity loan is a type of secured loan, lenders will place a lien on the property to back up the loan as a form of security. If you default on your loan, the lender can take ownership of your home as payment. 

Pro tip: In the simplest terms, home equity is the difference between the amount a homeowner owes on their mortgage(s) and the value of a home.

How does a home equity loan work?

Home equity loans work similarly to mortgages or some personal loans. When you take out a home equity loan, your lender will give you a lump sum of money. Technically, the money is a percentage of your home’s equity in cash. The percentage you get depends on several factors, including: 

• The home’s market value
• The borrower’s credit score
• The borrower’s payment history
• Loan-to-value ratio (LTV) or combined loan-to-value ratio (CLTV)

Pro tip: Your LTV measures the amount you still owe on your mortgage compared to the current, appraised value of your home. 

Once you receive the funds, you’ll start paying the lender back in fixed monthly installments, plus interest, over a set repayment term.

What can a home equity loan be used for?

Funds from a home equity loan can be used for almost anything. However, just because you can use the funds for anything doesn’t mean you should. Here are some of the best ways to use home equity loan funds:

• Home improvements: Any improvements or updates you make to your home will likely add value over time. Taking out a home equity loan to help with home-related projects may be a good use of funds. 

• Education: Although you can take out student loans for education-related costs, home equity loans typically have a lower interest rate compared to student loans.

• Debt consolidation: If you qualify for low home equity loan rates, you can use the funds to pay off high-interest debts.

• Emergency expenses: If you don’t have an emergency fund, you can use funds from a home equity loan to help pay for unexpected costs, such as medical expenses.

• Special events: If you need help funding a big, special event like a wedding or vacation, you can use the funds from your home equity loan to help cover costs.

• Auto purchase: You can use an auto loan to pay for a new car, but you can also use funds from a home equity loan to help pay for a new car. 

Pros and cons of a home equity loan

Before you decide to apply for a home equity loan, learn about the pros and cons to make sure it’s the right move for you.

Home equity loan pros:	Home equity loan cons:
Your loan will come with a fixed interest rate. You’ll have set monthly payments that make budgeting easier. You’ll have a clear payoff date. You’ll receive your loan in a lump sum.  Your home equity loan interest payments may be tax deductible.	You typically need a good to excellent credit score to qualify for the lowest interest rates.  You usually need at least 15% to 20% equity in your home to get approved.  You can’t withdraw more funds in an emergency.  You could lose your home if you default.

What are the home equity loan requirements?

Requirements for a home equity loan vary from lender to lender. To qualify, borrowers commonly need: 

• A minimum of 15% to 20% equity in the home 
• A “good” credit score (670 or higher)
• Proof of a stable income
• Healthy credit report 

How to get a home equity loan

The process is similar to getting a personal loan. You can get a home equity loan from a bank, credit union, online lender, or lending platform. After you’re done shopping around and comparing your options, you need to apply. 

Before you apply, gather the necessary documents. Depending on the lender you choose, you may need:

• A form of ID, such as a driver’s license, state ID, Social Security card, or passport
• Proof of income, like pay stubs, bank statements, or tax returns
• Evidence of your address, such as a utility bill, mortgage statement, or lease agreement
• List of your employment history and your employers’ contact information
• Proof you own the property 
• Copy of the home insurance 
• A recent mortgage statement
• Appraisal of your home
• Evidence of current liens on your home

Once the lender is done reviewing your application and checking your credit health through your credit report, they’ll tell you what you qualify for. Some of the details include how much you can borrow, the interest rate, monthly payment, loan term, and fees involved. 

If you accept the loan, the lender will provide the funds as a lump sum. After you receive the funds, you need to repay the lender in monthly payments for the agreed upon loan term. 

Home equity loan alternatives

Home equity loans can help you finance a big expense, but it’s not your only option. If you’re unsure about getting a home equity loan, consider these alternatives:

• Cash-out refinance: With a cash-out refinance, you refinance your original mortgage for more than the current balance, and you get the difference as a single lump sum. This is typically a good option if you can qualify for lower rates than you currently have on your first mortgage.
• Home equity line of credit (HELOC): A HELOC is similar to a home equity loan because it’s a type of loan backed by the equity in a borrower’s house. However, a HELOC is more like a credit card because the borrower can draw money when needed.
• Personal loan: Personal loans are typically unsecured and can be used for almost anything. If you’re not looking to put your house on the line, this might be a good financing option for you. But it’s important to keep in mind that interest rates for personal loans may be higher than they are for home equity loans.
• Credit card: You can use a credit card for big expenses, but it’s one of the most expensive options because interest rates are typically higher on credit cards. If you do use a credit card, create a plan to pay it off sooner rather than later so interest doesn’t accrue.

Home equity loan FAQs

Can I get a home equity loan with bad credit?

If you have a low credit score, it’s still possible to get approved for a home equity loan. However, it may be more difficult, and you may not qualify for the most competitive loan terms. To find a home equity loan with bad credit, you need to shop around and compare lenders because each has their own requirements.

Can you have a HELOC and a home equity loan at the same time?

You can take out a home equity line of credit (HELOC) and home equity loan simultaneously. However, you need to have enough equity built up in your home, in addition to the income and credit to get approved by the lender.

How much can you borrow on the equity of your home?

Typically, lenders prefer consumers borrow 80% or less of the equity in their home. It’s important to note that the loan amount and terms will also depend on your income, credit history, and how much your home is worth.

Is a home equity loan and mortgage the same?

Not exactly. A home equity loan and mortgage are similar, but there are a few key differences. A mortgage is a financing tool a borrower can use to fund the initial purchase of their home. A home equity loan is a tool homeowners can use once the home is purchased and equity has built up.

How much does a home equity loan cost?

Some lenders and lending platforms charge fees to take out or close a home equity loan. These will impact your annual percentage rate (APR), increasing the overall cost to take out a loan. Some common costs include:

• Application fee
• Origination fee 
• Closing costs
• Late fees 
• Annual fee
• Prepayment penalty 

Pro tip: For a home equity loan, you might also have to pay for title, flood, or property insurance, as well as additional taxes.

Next steps: home equity loans

If you know how much equity you need to take from your home, and you prefer a fixed interest rate, then a home equity loan may be a good choice for you. However, it’s essential to remember that a home equity loan is a big financial decision. If you take out too much equity, you can end up underwater on your mortgage. This means you can hurt your credit, and your home can go into foreclosure. 

Before you sign on the dotted line, do your research and consider your financial needs and loan options. Taking the time to plan will help ensure you make the best possible decision.