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Home Equity Loans: What Are They and How Do They Work?

If the value of your home is greater than what you owe on the mortgage, you may be able to borrow money using the home as collateral.
March 15, 2018
Finding the Right Mortgage, Mortgages
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A home equity lump sum loan, home equity line of credit and cash-out refinance are loans that use your property as collateral. To qualify for any of these loan products, you first need home equity. You have equity when your home’s value is higher than what you owe on the mortgage. The more equity you have, the more you should be able to borrow.

In general, you can borrow around 80% to 85% of your home’s value, minus what you owe on your mortgage.

Here’s how to get a rough estimate of the amount you may be able to borrow (or just let our home equity calculator do the math for you):

Let’s say your home is worth $350,000, your mortgage balance is $200,000 and your lender will allow you to borrow up to 80% of your home’s value.

$350,000 x 80% = $280,000

$280,000 – $200,000 = $80,000 (possible loan amount)

» MORE: 5 good reasons to tap your home equity

What is a home equity lump sum loan?

As the name implies, a home equity lump sum loan gives you money all at once. If you know how much money you’ll need and when you’ll need it — for a remodeling project with a fixed budget, for example — it may be the right choice.

This home equity loan, which is a second mortgage, is structured much like your purchase mortgage: You’ll repay this loan — principal and interest each month — at a fixed rate over a set number of years.

You can get a fixed interest rate and know that, at the end, you’re going to have a zero balance.

Carlos Miramontez, vice president of mortgage lending at Orange County's Credit Union

“You can get a fixed interest rate and know that, at the end, you’re going to have a zero balance,” says Carlos Miramontez, vice president of mortgage lending at Orange County’s Credit Union in California.

With a home equity loan or a HELOC, you could encounter a minimum loan requirement, which typically ranges from $10,000 to $25,000, according to Miramontez.

» MORE: A home equity loan is a smart choice as rates rise

Home equity loan pros:

  • Fixed rates provide predictable payments, which makes budgeting easier
  • Lower interest rates than a personal loan or credit card
  • Quicker close times than for a cash-out refinance
  • If your current mortgage rate is low, you don’t have to give that up

Home equity loan cons:

  • Less flexibility than a HELOC
  • You’ll pay interest on the entire loan amount, even if you’re using it incrementally, such as for an ongoing remodeling project
  • More lenders are offering HELOCs than home equity lump sum loans

Typical requirements:

  • Home equity of at least 15% to 20%, usually confirmed by an appraisal
  • A credit score of 620 or higher
  • Debt-to-income ratio of 43%, or possibly up to 50% (calculate your DTI)

» MORE: The best home equity loan lenders of 2018

What is a home equity line of credit (HELOC)?

Unlike the home equity lump sum loan, a HELOC provides flexibility by letting you borrow what you need, pay it off and borrow again; it’s similar to using a credit card. In fact, a HELOC often comes with a credit or debit card, or a book of checks.

The other main difference is that HELOCs have variable interest rates, which means your rate could rise or fall over the life of the loan, making your payments less predictable. In general, the rate on a HELOC will be discounted in the beginning. But after an introductory phase of around six to 12 months, the interest rate goes up.

» MORE: Home equity loan vs. HELOC: pros and cons

HELOCs are generally structured in two phases: the draw period and the repayment period.

During the draw period, which often lasts 10 years, you can borrow money from the credit line, often only requiring you to make payments on the interest. But after the draw period ends, you’re no longer able to take out money and the repayment phase begins. At this point, your monthly payments must cover both interest and principal.

It’s a good idea to repay both interest and principal during the draw period, if you can.

If you’ve avoided paying the principal during the draw period, you’ll face much larger payments during the repayment period, which can catch some borrowers off guard. That’s why it’s a good idea to repay both interest and principal during the draw period, if you can.

During the HELOC’s repayment period, which often lasts 20 years, your lender may give you the option of converting your loan balance to a fixed interest rate.

HELOC pros:

  • Often have low introductory rates and payments (here’s how to get the best HELOC rates)
  • Can be cheaper overall than other types of home equity borrowing, depending on interest rates and how long you hold the loan
  • Instant access to loan funds
  • No interest payments on unused funds

HELOC cons:

  • It’s a more complex loan product, and comparison shopping can be difficult
  • Variable interest rates can make payments unpredictable
  • Payments can grow by a lot after the draw period ends if you haven’t been paying down the principal
  • Lines of credit can be abruptly “frozen” or reduced by the lender
  • Some HELOCs require borrowers to draw a minimum amount immediately, a potential problem if you don’t need the money right away

Typical requirements:

  • Home equity of at least 15% to 20%, usually confirmed by an appraisal
  • A credit score of 620 or higher
  • Debt-to-income ratio of 43%, or possibly up to 50% (calculate your DTI)

» MORE: Best HELOC lenders of 2018

What is a cash-out refinance?

A third way to tap your home equity is a cash-out refinance. Unlike the home equity lump sum loan and HELOC, which are second mortgages (on top of your first), a cash-out refi replaces your existing mortgage with one that totals more than you owe on your home.

The ‘more than you owe’ portion is the money you ‘cash out’ and spend on what you need.

The “more than you owe” portion is the money you “cash out” and spend on what you need. By comparison, a traditional refi replaces your existing mortgage with a new one for the same loan balance.

Cash-out refinancing can make sense if the interest rate offered is lower than the rate on your existing mortgage. But if your mortgage already has a low rate and refinancing results in a loan with a higher rate, a better option may be a home equity loan or HELOC.

» MORE: How to use a cash-out refinance

Cash-out refi pros:

  • When rates are low, you can drop the interest rate while pulling out cash
  • Rates are higher than a traditional refinance but lower than a second mortgage

Cash-out refi cons:

  • You might give up a lower-rate mortgage if refinancing when rates are rising
  • Closing costs are higher than for home equity loans and HELOCs

Typical requirements:

  • You generally need to have at least 20% equity in your home
  • Minimum credit score 740 for the lowest rates
  • Debt-to-income ratio under 45%

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