What is a home equity loan?

Home equity loans have been a popular tool for homeowners in recent years. In fact, according to TransUnion, nearly 240,000 home equity loans were issued in just the second quarter of 2023 alone. That’s up 18% compared to last year and a whopping 61% increase over 2020.

The reasons for this spike are many, but higher rates on credit cards and other financial products play a role (home equity loans’ low interest rates make them a good option for paying these higher-interest debts off). Rising interest in home renovations — something home equity loans are often used to cover — also factor in.

Are you one of the many homeowners considering a home equity loan to pay off debts or to cover home renovations? If so, here’s what you need to know.

A home equity loan is a type of second mortgage — meaning a mortgage that’s in addition to the main mortgage you already have on your property. 

These loans allow you to borrow from your home equity — the portion of your home you actually own — and turn it into cash, which you can then use for any purpose. Many homeowners use home equity loans to pay for home renovations or consolidate debts, as noted earlier, but some use them for other needs, too, like paying for college, covering unexpected medical bills, and more. 

To determine how much equity you have, subtract your main mortgage balance from your home’s value. If your home is worth $500,000, for example, and you have a mortgage balance of $200,000, you’d have $300,000 in equity you could potentially borrow from. (Though most lenders will only let you borrow only a portion of that). 

When you take out a home equity loan, you borrow from your equity and then get that equity back in cash — as a single lump sum. 

Then, just like with your main mortgage, you repay the money, plus interest, every month until your balance is zero. The exact terms vary by lender, but you’ll usually have anywhere from five to 30 years to pay back a home equity loan.

One of the biggest advantages of home equity loans is their interest rates. Not only are home equity loan rates fixed, but they also tend to be lower than the interest rates on other financial products.

According to Bankrate, the average rate on home equity loans is 8.61% right now. On credit cards, it’s nearly 21%. This disparity makes home equity loans a more affordable choice to pay for home renovations and other costs you might face. Home equity loans can also be a smart tool for paying off credit card balances and other high-interest debt.

Some other perks: You can use the funds from a home equity loan for any purpose, and you get an extended period to pay it off — usually somewhere between five and 30 years, though you’ll want to understand the terms before taking off the loan. There may even be a tax write-off if you use the money to “buy, build, or substantially improve” your house, per IRS rules.

On the downside, though, home equity loans use your home as collateral, which could be dangerous if you find yourself in financial trouble. As Kyle Enright, president of Achieve Lending, explains, “If you miss payments, you could face foreclosure.”

Home equity loans also come with closing costs, and you’ll owe interest on the entire loan amount. (This is different from HELOCs — another type of home equity product). 

Unlike home equity loans, HELOCs don’t give you a lump sum payment. Instead, you get a line of credit, sort of like a credit card, from which you can withdraw money over time — usually a period of 10 years. Then, you pay that money back, plus interest, once you enter the repayment period. This is typically 20 years on most HELOCs.

With HELOCs, you only pay interest on what you withdraw — not the entire credit line. Be careful, though: Most HELOCs have variable rates, which means the interest rates fluctuate over time. Some lenders offer fixed-rate HELOC options, though they’re not as common.

To get a home equity loan, you’ll first need equity in your property. The exact amount varies by lender, but most companies will allow you to borrow up to 80 or 90% of your home’s value, minus your current mortgage balance. (This is called your loan-to-value ratio, or LTV). 

Other requirements depend on the mortgage lender, but generally, “Lenders typically look for a substantial amount of equity in your home, a decent credit score — usually around 620 or higher, a healthy debt-to-income ratio, and a stable income and employment history,” says Alex Shekhtman, CEO and founder of LBC Mortgage.

Some lenders will accept scores lower than 620, though they usually come with higher interest rates. Better scores mean the opposite.

As Enright puts it, “The higher the score, the lower the interest rate.”

Interest rates also vary between companies, so make sure you shop around for your lender if you’re eyeing a home equity loan. Compare each option on fees, rates, loan terms, and closing costs, and make sure you’re getting the best possible deal for your loan.

You can also work with a mortgage broker. They’ll help you determine the best lender and loan option for your needs.

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was first published on SFGate.com and reviewed by Lauren Williamson, who serves as Financial and Home Services Editor for the Hearst E-Commerce team. Email her at [email protected].