A home equity loan lets you borrow against the value you have built up in your home. It can be a smart way to fund large expenses at a lower interest rate than credit cards or personal loans. But using your home as collateral means the stakes are high if you cannot repay. Here is what you need to know before taking one out.
What Is a Home Equity Loan?
A home equity loan is a type of second mortgage. You borrow a lump sum of money and repay it over a fixed period at a fixed interest rate. Your home serves as collateral, which is why these loans typically have lower rates than unsecured debt like personal loans or credit cards.
The amount you can borrow depends on how much equity you have in your home. Equity is the difference between your home’s current market value and what you owe on your mortgage.
How Does a Home Equity Loan Work?
Once approved, you receive the full loan amount upfront. You repay it in fixed monthly installments over the loan term, usually 5 to 30 years. The interest rate is fixed for the life of the loan, so your payment stays the same each month.
How Much Can You Borrow?
Most lenders allow you to borrow up to 80% to 85% of your home’s appraised value, minus what you still owe on your mortgage. For example:
- Home value: $400,000
- Mortgage balance: $200,000
- Maximum combined borrowing (85% of $400,000): $340,000
- Subtract mortgage balance: $340,000 – $200,000 = $140,000 available to borrow
Home Equity Loan vs. HELOC
A home equity line of credit (HELOC) is similar but works differently. A HELOC is revolving credit, like a credit card, where you borrow what you need, repay it, and borrow again during a draw period. The interest rate on a HELOC is typically variable.
A home equity loan gives you a fixed lump sum at a fixed rate. It is better when you know exactly how much you need and want predictable monthly payments. A HELOC is better when you need flexibility to borrow in stages, like during a home renovation project.
What Can You Use a Home Equity Loan For?
Lenders do not restrict what you can use a home equity loan for, but some uses make more financial sense than others.
Good Uses
- Home renovations that increase your home’s value
- Paying off high-interest credit card debt
- Significant medical expenses
- Education expenses
- Emergency repairs
Risky Uses
- Vacations or luxury purchases
- Everyday expenses
- Speculative investments
Using a home equity loan to fund non-essential spending is risky because your home is the collateral. If you default, you could lose your home.
Is the Interest Tax Deductible?
Interest on a home equity loan may be tax deductible if you use the funds to buy, build, or substantially improve the home that secures the loan. If you use the funds for other purposes like paying off credit cards or covering personal expenses, the interest is generally not deductible. Consult a tax professional to confirm your specific situation.
Requirements for a Home Equity Loan
Lenders typically look for:
- At least 15% to 20% equity in your home
- Credit score of 620 or higher (some lenders require 680+)
- Debt-to-income ratio below 43%
- Stable income and employment history
- A current appraisal of your home
What Are the Risks?
The biggest risk is losing your home. If you miss payments on a home equity loan, the lender can foreclose. This makes it fundamentally different from other types of loans where default damages your credit but does not cost you your home. Only borrow what you can confidently repay.
Another risk is declining home values. If your home’s value drops, you could end up owing more than the home is worth, a situation called being underwater.
How to Apply
Get quotes from multiple lenders including your current mortgage lender, credit unions, and online lenders. Compare interest rates, closing costs, and loan terms. The application process typically requires pay stubs, tax returns, bank statements, and a home appraisal. Closing takes two to four weeks in most cases.
The Bottom Line
A home equity loan is a powerful financial tool, but it comes with real risk because your home is on the line. Use it strategically for expenses that improve your financial position, not for discretionary spending. Shop around for the best rate, and never borrow more than you can comfortably repay.