Understanding What Home Equity Loans Are and How They Work

If you’ve lived in your home for a few years now, there’s a good chance you've built up some equity. Home equity is the value of your home (what it's currently appraised for) minus the balance remaining on your mortgage. For example, if your home is worth $250,000 and you only have $100,000 left to pay, you now have $150,000 in equity.

Whereas you can let the equity continue to build, you also have the option of taking some of it out. This can usually be done through a home equity loan, a home equity line of credit (HELOC), or by refinancing your mortgage. If you’re considering taking the equity out of your home but aren’t sure how to best execute it, read on for a detailed overview of each of your options.

A home equity loan acts similarly to other types of loans, in that it allows a homeowner to borrow money from a lender (against their equity) and receive a lump-sum payment. Home equity loans can be taken out through your current lender or others who offer this service and must be repaid on a monthly basis.

Loan amounts vary. Typically, mortgage lenders are most comfortable with capping you out at 80 percent of the equity you’ve accrued.

When you apply for and are approved for a home equity loan, you’ll receive your money with a fixed interest rate attached to it. A fixed interest rate is one that doesn’t change, and it usually ranges from 2 to 11 percent. These rates are determined using your income, the term you choose (which can last 5 to 30 years), and your credit history.

For instance, if you were to agree to a 15-year fixed home equity loan, you might pay between 2.25 and 11.75 percent in interest. A portion of your monthly payment will go toward paying down your loan balance, while the other portion will be used to satisfy the interest.

One good feature of home equity loans is that the interest you pay may be tax deductible. If you use your home equity loan to make improvements to your home, such as building onto the property or remodeling inside, you can then claim the interest paid on taxes.

Home equity loans serve as one way for property owners to reap the benefits of building up the equity in their homes. However, home equity loans are considered a second mortgage in a sense, because you're now taking on a second payment. In addition to paying your usual monthly mortgage payment, you would need to satisfy your loan payment should you decide to take out a loan against your home’s equity.

There are as many advantages to taking out a home equity loan as are there disadvantages. If you’re considering taking out a loan against your home, it’s important to be aware of both so you can make an informed decision. To get started, let’s consider some of the reasons it might be a good idea to take out a home equity loan.

1. You want to invest in another property. If you found another property you’d like to use as an investment property, a home equity loan might allow you to buy it.

2. You’re looking to consolidate debt. Credit card companies and other types of lenders often tack on high interest rates, making it harder for you to pay down your debt. If you use a home equity loan to consolidate your debt, you’ll be able to better manage your finances at a lower interest rate.

3. You want to make a large purchase, such as buying a vehicle or starting a business.

Although a home equity loan can give you access to money when you most need it, it can put your property at risk of foreclosure. If you default on your monthly loan payments, the lender could come after your home if you fail to bring your account to good standing.

Home equity loans might also result in you paying more in interest if it's stretched out over a long period of time. You may want to consult a financial advisor before taking out a home equity loan so you know how much you’ll be paying in interest and whether it’s the best option for you to gain access to funds.

Another downfall to home equity loans is their risk of putting you back into debt. For example, if you were to use your loan to pay off your credit card debt and then continue spending on your credit cards, you wouldn't have accomplished your goal of eliminating your debt.

A home equity line of credit (or HELOC) works similarly to a credit card. Your line of credit is based on your credit history, property value, and the amount of equity you’ve accrued. Once approved, you’ll be provided with a spending limit and a variable interest rate.

A variable interest rate is one that isn't fixed, meaning it can change. The interest rate for a HELOC comprises the prime rate plus whatever interest rate the lender sets, which could be 1 to 2 percent or even higher. Should the prime rate rise, your interest rate will, too.

Whereas HELOCs don’t require you to pay any interest on money you don’t access, you could be paying a significant amount if you take out the entire line of credit and the interest rate jumps. And although a HELOC generally won’t provide you with a fixed interest rate, it will give you the flexibility to spend the money as you need it.

Now, your lender is the party that will stipulate the length of time for which you can access your HELOC (which is usually 10 years). Once that draw period ends, you'll need to be re-evaluated to determine whether you can continue with your current rates or if a new agreement needs to be established.

Two key differences between a HELOC and a home equity loan is that you can take out and put back the money at any time. A HELOC is also considered an interest-only loan, which means you're only required to pay interest on whatever you borrow each month.

A HELOC might also be a suitable choice if you want to pay lower upfront costs or if you would prefer to access your home’s equity on your terms. One characteristic that HELOCs and home equity loans do share, however, is that neither option requires closing costs.

When you refinance your home for a cash-out on your equity, you’re essentially paying off your current mortgage and signing a new mortgage agreement. For example, let’s say you bought your home for $100,000 and it's now worth $200,000. You initially paid $20,000 to cover the 20 percent downpayment and there's $50,000 remaining on your mortgage.

Given these figures, your equity is now around $150,000. If you wanted to cash out your equity (or a portion of it), you could complete a cash-out refinance: after securing a lender to help you execute the refinancing process, you would sign a new mortgage agreement for the current price of your home.

Using our example above, your new loan amount would be $200,000, though you would still have a mortgage balance of $50,000.

Once your new loan agreement is signed and you agree to the new terms (which will likely include varying interest rates and a new payment schedule), you would be entitled to collect the equity in the form of a lump-sum payment. However, you'll need to pay off your current mortgage with these funds.

To take out a home equity loan, certain requirements that must be met. For starters, you must have accrued enough equity to take out a loan. If market prices are low and you haven’t paid much toward your mortgage, there may not be enough for a lender to even consider offering you a loan.

Additionally, you’ll need to have a positive credit history and income to show you're trustworthy and capable of paying any money you borrow back.

For a lender to determine how much equity you’ve accrued, you’ll need to have your property appraised. The lender can then calculate how much you have in equity. You should be aware that if market prices are low or there isn’t much demand for a property like yours, your equity amount won’t be as high as it would be if the market were hot.

If you don’t have enough equity built up to take out a loan or line of credit, there are a few ways you can build your home equity:

1. Continue paying down your mortgage.
2. Make improvements to your home. When you remodel or expand on your home, it could increase its value, allowing you to get more equity out of it.
3. Put down a large downpayment.

Although these factors can help increase your equity, your property’s appreciation value will also play a significant role in determining how much equity you can take out of it. For instance, during times of inflation and increased demand for properties, your equity will likely be much higher.