A home equity loan is a way to finance a large purchase, such as a complete home renovation, or to consolidate high-interest debt by tapping into the equity from your home. Your home secures the loan, and the funds are fully disbursed in one payment.
With your home as collateral, lenders have reason to believe you’ll make full, timely payments, so they offer a lower interest rate than they would on most unsecured loans. However, failing to make the monthly payments could result in foreclosure.
Yet for borrowers who are confident they can make the payments, a home equity loan can be an affordable financing option. Keep reading to learn more about home equity loans and whether securing one makes sense for you.
Table of Contents
Key Points
• A home equity loan is a fixed-rate loan secured by a home, providing a lump sum of money.
• Home equity is calculated by subtracting the mortgage balance from your home’s current market value.
• Requirements for a home equity loan include sufficient equity, stable income, credit history, and a low debt-to-income ratio.
• Advantages include low interest rates and large borrowing amounts; the chief drawback is the potential for foreclosure.
• A home equity line of credit (HELOC) is an alternative to a home equity loan and is also secured by a home.
What Is a Home Equity Loan?
A home equity loan is typically a low-interest, fixed-rate loan that’s secured by a home.
Repayment terms are normally 5-30 years.
How Do Home Equity Loans Work?
First, you’ll need to have sufficient home equity, which is the difference between the market value of your home and what you owe on your mortgage. You may have built home equity through home appreciation and by paying down your mortgage.
You’ll go through an application process, and the lender will likely order a home appraisal to ensure that there’s enough value there to lend against.
You’ll have a lot more paperwork than with some other loans, and you’ll sign a mortgage lien or legal claim documents that give the lender the right to start foreclosure proceedings should you fail to make payments.
After closing on the loan, you’ll receive all funds upfront, with repayment normally consisting of fixed monthly installments.
Homebuyers also occasionally use a home equity loan as part of a piggyback loan to avoid paying private mortgage insurance (PMI) on a new home. An 80/10/10 piggyback mortgage, for example, consists of a conventional home loan, a second mortgage, such as a home equity loan, and a 10% down payment. This is especially helpful for those who can only put less than 20% down in cash.
Types of Home Equity Loans
When you’re looking to use the equity in your home, there are three types of home equity loans to choose from: a home equity loan, a home equity line of credit (HELOC), and a cash-out refinance.
• Home equity loan: The loan is disbursed in one lump sum and paid back over time. The interest rate is typically fixed.
• HELOC: The way a HELOC works is through a draw period, during which money can be taken out as you need it, up to the limit you were approved for, often paying monthly interest. This draw period, which usually lasts around 10 years, is followed by a repayment period, which is when outstanding principal and interest payments are made. The interest rate on this kind of loan is variable.
• Cash-out refinance: A third way of freeing up equity is through cash-out refinancing. This means taking out a new mortgage for more than you owe on your current mortgage. You use the loan to pay off your current mortgage, and you’re also left with a lump sum to spend as you please.
Home Equity Loan Requirements
Home equity loans are contingent on:
• The amount of home equity a homeowner has
• Income
• Credit history
• Debt-to-income ratio
How to Calculate Your Home Equity
Calculating home equity requires basic math: Subtract the amount you owe from the market value of your home. If your home is worth $500,000 and you owe $350,000, you have $150,000 in equity.
However, you usually won’t get a loan for the total amount of your home equity. When it comes to how much home equity you can tap, many lenders allow a maximum of 80%, while some may allow up to 85% or 90%.
If you’re taking out a second mortgage, such as a home equity loan or HELOC, your first mortgage and the equity loan compared with your home value is what is called the combined loan-to-value (CLTV) ratio.
Many lenders will require a CLTV of 80% or less for a home equity loan. HELOC limits vary by lender, but many allow borrowing up to 80% to 90% of your home’s value.
combined loan balance Ă· appraised home value = CLTV
Example of a Home Equity Loan Payment
Something that attracts a lot of borrowers to a home equity loan is the flexible repayment period, which usually allows homebuyers to choose a mortgage term of 5-30 years.
A longer repayment period can make your monthly payment on your mortgage more manageable. For example, if you were to get a $75,000 home equity loan with a repayment period of 20 years, your monthly payment at 8% interest would be $627. If you had to repay that same amount in five years, your payment would be $1,521.
Here’s a chart comparing examples of monthly payments with different terms:
| Loan amount | Interest rate | Term | Monthly Payment |
|---|---|---|---|
| $75,000 | 8% | 5 years | $1,521 |
| $75,000 | 8% | 10 years | $910 |
| $75,000 | 8% | 20 years | $627 |
Many variables can affect the rate you pay, such as your credit score and your loan-to-value rate. Also, keep in mind that the longer the loan term, the more interest you’ll pay, despite the more affordable monthly payment.
Difference Between Home Equity Loans and HELOCs
Whether you apply for a HELOC or home equity loan, you use your house as collateral. The difference is in how you receive and repay the money.
| Home equity loan | HELOC |
|---|---|
| Lump sum loan | Money as you need it |
| Start repaying immediately | Pay only on the amount you borrowed |
| Normally a fixed interest rate | Often a variable interest rate |
| Installment loan | Credit line |
Advantages and Drawbacks of Home Equity Loans
Home equity loans have some advantages, but it’s important to consider the drawbacks as well.
thumb_up
Advantages:
• Large amounts of money can be borrowed
• Low interest rate
• Flexible use
thumb_down
Drawbacks:
• Uses the home as collateral
• Repayment begins immediately
• Set loan amount, so if you need more money, you’ll need to apply for another loan
Home Equity Loan Quiz
What Can You Use a Home Equity Loan For?
The great thing about a home equity loan is the wide range of things you can use it for. Once the funds flow into your bank account, they’re yours to use for almost any purpose. Some common uses of home equity are:
• Home renovations
• Education expenses
• Medical expenses
• Consolidation of high-interest revolving debt
• Recreational vehicles
• Vacations
• Weddings
• Purchase of an investment property
• Building an accessory dwelling unit
• Money in retirement
While you can pay for college tuition with a home equity loan, it might be better to find a student loan for that expense. Also, vacation expenses, wedding costs, vehicles, and even retirement funds might be better addressed by saving and planning than by dipping into home equity.
Why? Because that way you’re not putting your home at risk if you’re unable to pay.
How to Apply for a Home Equity Loan
Step 1: Assess your situation. Do you have enough equity to make this happen? How much do you need? Would you prefer a home equity loan or a HELOC? Do you have at least a “good” FICO® score?
If you have an idea of what type of loan you want, how much you want to borrow, and how much equity is available to tap, you’ll be able to shop for what you need.
Step 2: Ask multiple lenders for loan estimates. Getting loan estimates from different lenders can help you find the best terms and rates. Compare the annual percentage rate (APR) of one 20-year loan to another, and so on. The APR will include the loan’s interest rate and any points and fees. Some lenders offer to waive or reduce closing costs on the loan, but the interest rate on these loans may be higher as a result.
In general, hard credit inquiries made within about 14-45 days may be treated as a single inquiry for credit-scoring purposes.
Step 3: Find a fitting loan and apply. Submit information about your income, current mortgage, insurance, and other details that the lender requests. The lender may require an appraisal of your home.
Step 4: Close on your loan. If everything checks out, including your income, the credit history on your credit reports, and the home value, you may reach the closing table for your home equity loan. The Federal Trade Commission recommends reading the closing documents carefully and negotiating changes or walking away if something doesn’t look as it should.
Step 5: Receive your funds. Funds are typically received within a few business days after closing.
Step 6: Begin repaying your loan. On a home equity loan, once the funds are disbursed upfront and your interest rate is locked, the first payment will be due around 30 days after you close on the loan.
Is It a Good Idea to Take Out a Home Equity Loan?
Taking out a home equity loan can be one of the least expensive ways to finance a large purchase. Because your home secures the loan, a home equity loan may offer a lower interest rate than some other borrowing options, but costs vary by lender and loan terms.
For people who want borrowing flexibility and aren’t sure of the exact amount they will need, a HELOC might be a better option.
While a lower interest rate is great, you should always keep in mind that your home is at risk with a home equity loan. If you are confident you can make the payments and need a large sum, this may be a financing solution to consider.
The Takeaway
With a relatively low interest rate and a repayment period that can be long, a home equity loan is an attractive way to finance a large purchase or consolidate high-interest debt. A home equity line of credit can be a good alternative with even more flexibility.
SoFi now partners with Spring EQ to offer flexible HELOCs. Our HELOC options allow you to access up to 90% of your home’s value, or $500,000, at competitively lower rates. And the application process is quick and convenient.
FAQ
How much can you borrow with a home equity loan?
Most lenders limit the amount to 80% of your home equity, though that is not always the case. The loan amount also depends on your income, debt, and creditworthiness.
Can you have multiple home equity loans at the same time?
Yes, you can have more than one home equity loan at a time. However, it’s a good idea to consider all your options before getting another loan that puts your home at risk.
Are home equity loans tax-deductible?
Interest on home equity loans is tax-deductible if the money is used to buy, build, or substantially improve the home that secures the loan. You’ll want to work with a tax advisor to make sure you adhere to the rules around this deduction.
Are there costs to getting a home equity loan?
Closing costs for a home equity loan are typically 2%-5% of the loan amount. However, some lenders don’t charge any closing costs.
How do you pay back a home equity loan?
Repayment begins shortly after the funds are disbursed. These are normally paid through monthly installments until the loan term ends.
Photo credit: iStock/VioletaStoimenova
SoFi Mortgages
Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility-criteria for more information.
SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.
*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.
²SoFi Bank, N.A. NMLS #696891 (Member FDIC), offers loans directly or we may assist you in obtaining a loan from SpringEQ, a state licensed lender, NMLS #1464945.
All loan terms, fees, and rates may vary based upon your individual financial and personal circumstances and state.You should consider and discuss with your loan officer whether a Cash Out Refinance, Home Equity Loan or a Home Equity Line of Credit is appropriate. Please note that the SoFi member discount does not apply to Home Equity Loans or Lines of Credit not originated by SoFi Bank. Terms and conditions will apply. Before you apply, please note that not all products are offered in all states, and all loans are subject to eligibility restrictions and limitations, including requirements related to loan applicant’s credit, income, property, and a minimum loan amount. Lowest rates are reserved for the most creditworthy borrowers. Products, rates, benefits, terms, and conditions are subject to change without notice. Learn more at SoFi.com/eligibility-criteria. Information current as of 06/27/24.In the event SoFi serves as broker to Spring EQ for your loan, SoFi will be paid a fee.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Checking Your Rates: To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. However, if you choose a product and continue your application, we will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and may affect your credit.
Non affiliation: SoFi isn’t affiliated with any of the companies highlighted in this article.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOHE-Q126-087