What is a home equity loan? a way to borrow money against your home
Personal Finance Insider writes about products, strategies, and advice to help you make smart decisions with your money. We may receive a small commission from our partners, such as American Express, but our reports and recommendations are always independent and objective. Terms apply to offers listed on this page. Read our editorial standards.
- A home equity loan is a second mortgage that uses your home as collateral.
- Most lenders will allow you to borrow up to a combined ratio of 75% to 90% of the value of your home.
- Your home will be at risk if you fail to make your monthly payments.
- Learn more about personal finance coverage.
If you are considering make improvements to your homeask for help paying for your child’s college education or other major expenses, tap into the equity in your home could be a way to get your hands on a large sum of money.
For many homeowners, a home equity loan could give them access to more money than any other type of loan. Additionally, these loans often come with better interest rates and terms than other forms of debt, such as credit cards and personal loans.
But home equity loans also come with their fair share of risk. Here’s what you need to know about home equity loans before you start contacting lenders and filling out loan paperwork.
What is a home equity loan?
A home equity loan is a type of second mortgage that uses your home as collateral and allows you to borrow against the current value of your home. If your home is worth $200,000 and you only owe $100,000 on your mortgage, you currently have $100,000 of “equity” in your home. And you may be able to borrow against some of that equity with a home equity loan.
With a home equity loan, you borrow the entire amount of money up front and then make equal monthly payments on a Amortization schedule, which tells you how much you’ll pay each month for principal and interest. The repayment terms of a home equity loan can vary from five to 30 years and the interest rate is usually fixed.
Home Equity Loan vs. Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) is similar to a home equity loan in that both types of debt involve the homeowner borrowing against the value of their home. However, a HELOC works more like a credit card. You get a credit limit that you can borrow against repeatedly for a set period of time called a “drawdown period”.
Once the “drawdown period” on a HELOC ends, the line of credit will no longer be available to the borrower and regular amortized payments will begin. HELOC terms can vary, but often have drawdown periods of five to 10 years, followed by a repayment period of 10 to 20 years. Unlike a home equity loan, a HELOC usually comes with a variable interest rate.
How much money can you borrow with a home equity loan?
First, lenders generally won’t allow you to borrow more than the current value of your home. In fact, most lenders will set a combined loan-to-value (LTV) ratio of 75% to 90%. If your house is worth $300,000 and you owe $150,000, your current LTV ratio is 50% ($150,000/$300,000 = 0.50).
Let’s say you were looking to borrow $50,000 from a lender that has a combined LTV limit of 80%. If you add $50,000 to your current mortgage balance of $150,000, your new combined total debt would be $200,000.
If you take $200,000 and divide it by $300,000, you will find that your combined LTV after taking out the home equity loan would be 67%. That’s well below your lender’s 80% limit, which could mean you’d have a high chance of qualifying for the loan.
However, let’s say you wanted to borrow $100,000. In this case, your combined loan after taking out the home equity loan would become $250,000 ($150,000 + $100,000 = $250,000).
When you take $250,000 and divide it by $300,000, you get 83% ($250,000/$300,000 = 0.83). Since this would be above the lender’s combined 80% LTV limit, you would not qualify for a $100,000 home equity loan from that particular lender.
Advantages and disadvantages of home equity loans
What to look for in a home equity loan
When comparing lenders, here are some factors you’ll want to pay attention to:
- Interest rate: Is the interest rate fixed or variable?
- Terms: How many years will you have to repay the loan?
- Costs: Does the lender charge an application, origination or appraisal fee?
- Closing costs: Will you be expected to bring money to the closing table? If yes how much ?
Although you may be tempted to focus solely on finding the lender with the lowest interest rate, the other factors listed above are also important.
For example, if lender A is willing to offer you a five-year longer repayment term than lender B, your monthly payments with lender A could be much more affordable, even with a slightly higher interest rate.
Beware of home equity loan scams
The Federal Trade Commission (FTC) warns that there are many unethical home lenders offering high cost home loans. Many of these lenders target seniors or low-income homeowners or
These lenders often use deceptive or illegal tactics to take advantage of people, such as “equity stripping”. With equity stripping, lenders provide equity loans to homeowners who do not have the income to repay the loan, putting them at significant risk of losing their home.
If you feel like you’ve been coerced into taking out a home equity loan by an unscrupulous lender, federal law gives you up to three days to cancel the loan without penalty. Learn more about harmful home equity lending practices and your rights.
Before you sign anything, be sure to read all of the loan closing documents carefully. And research lenders online to see what others are saying about how they run their businesses. To finish, using a mortgage broker could help you find a reputable lender with the best deal.
Taking out a home equity loan could be a good option to cover an expense that you might not otherwise be able to afford. But understand that if you don’t repay your loan, you could lose your home.