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How a Home Equity Loan Works

A home equity loan lets you borrow money using your home as collateral. You'll get a lump-sum payment and repay the loan with fixed-rate interest over a predetermined term.
July 9, 2020
Finding the Right Mortgage, Mortgages
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A home equity loan is one way to tap into your home’s worth. But since your home is the collateral for an equity loan, failure to repay could put you at risk of foreclosure. If you’re considering taking out a home equity loan, here’s what you should know.

What is a home equity loan?

A home equity loan can provide you with cash in the form of a lump-sum payment that you pay back at a fixed interest rate, but only if enough equity is available to you.

Equity is the difference between your home’s value and what you still owe on the mortgage. Steadily paying down your mortgage is one way to grow your home equity. And if real estate values go up in your area, your equity may grow even faster.

Thinking about a home equity loan?

Home equity loans can be a great way to finance your home improvements. NerdWallet helps you easily see how much equity you have available.

How does a home equity loan work?

A home equity loan gives you access to a lump sum of money all at once. If you know how much money you’ll need and when you’ll need it — to finance a remodeling project with a set budget, for example — it may be the right choice.

You’ll repay the home equity loan — principal and interest each month — at a fixed rate over a set number of years. Be sure that you can afford this second mortgage payment in addition to your current mortgage, as well as your other monthly expenses.

» MORE: Compare home equity loan rates

How much can you borrow with a home equity loan?

A home equity loan generally allows you to borrow around 80% to 85% of your home’s value, minus what you owe on your mortgage. You can do some simple math to estimate how much you might be able to borrow.

How to calculate your maximum home equity loan.

For example, say your home is worth $350,000, your mortgage balance is $200,000 and your lender will allow you to borrow up to 85% of your home’s value. Multiply your home’s value ($350,000) by the percentage you can borrow (85% or .85). That gives you a maximum of $297,500 in value that could be borrowed. Subtract the amount remaining on your mortgage ($200,000), and you’ll get the approximate sum you can borrow as a home equity loan — in this case, $97,500.

Alternately, you can ditch the math and use our home equity loan calculator.

Home equity loan requirements

Qualification requirements for home equity loans will vary by lender, but here’s an idea of what you’ll likely need in order to get approved:

  • Home equity of at least 15% to 20%.
  • A credit score of 620 or higher.
  • Debt-to-income ratio of 43% or lower.

In order to confirm your home’s fair market value, your lender may also require an appraisal to determine how much you’re eligible to borrow.

Are home equity loans a good idea?

Whether a home equity loan is a good idea or not depends on your financial situation and what you plan to do with the money. Using your home as collateral carries substantial risk, so it’s worth the time to weigh the pros and cons of a home equity loan.

PROS:

  • Fixed rates provide predictable payments, which makes budgeting easier.
  • You may get a lower interest rate than with a personal loan or credit card.
  • If your current mortgage rate is low, you don’t have to give that up.
  • If you use the loan for home improvements or renovation, the interest may be deductible.

CONS:

  • Less flexibility than a home equity line of credit.
  • You’ll pay interest on the entire loan amount, even if you’re using it incrementally, such as for an ongoing remodeling project.
  • As with any loan secured by your house, missed or late payments can put your home in jeopardy.
  • If you decide to sell your home before you’ve finished paying back the loan, the balance of your home equity loan will be due.

» MORE: The best home equity loan lenders

What’s the difference between a home equity loan and a HELOC?

Unlike the single lump sum of a home equity loan, a home equity line of credit, or HELOC, provides flexibility. There’s still a total loan amount, but you only borrow what you need, then pay it off and borrow again. That also means you pay back a HELOC incrementally based on the amount you use rather than on the entire amount of the loan, like a credit card.

The other key difference is that HELOCs have adjustable rates. Your rate could rise or fall over the life of the loan, making your payments less predictable. HELOC rates are often discounted at the beginning of the loan. But after an introductory phase of around six to 12 months, the interest rate typically goes up.

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

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