What is a Home Equity Loan? How the Financing Option Works & Differs from a HELOC

What Is A Home Equity Loan

Whether you adore your New York penthouse view or the fresh air at your farmhouse in Iowa, you can also be proud of the equity you’ve built up in your home over the years. It is a valuable asset that can continue to grow and can serve as excellent collateral for a home equity loan.

A home equity loan is money you can borrow by tapping into your home’s value minus what you still owe on a mortgage loan — although many people I know call it a second mortgage. It provides a fixed amount that you repay over a set period in regular monthly installments.

A home equity loan is one in which you borrow cash against your home’s value, using the home as collateral. But that means you are putting your home at risk if you fail to pay back the loan.

Getting a home equity loan from a reputable lender can be a bit of a complex process, but I can walk you through how to get started. You’ll also learn how it stacks up against a home equity line of credit so you can figure out which option might be best for you.

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Home Equity Loan Basics

Now, before you jump in at the deep end, it’s important to understand precisely how a home equity loan actually works. Master the mechanics, and you’ll be far better positioned to use the value in your home to your advantage while avoiding the likely bumps in the road.

How to Determine Your Equity 

The first step to knowing how much you can borrow through a home equity loan is working out how much equity you have. Equity is the difference between what your home is worth and how much you still owe on it. As time goes by, you pay down your mortgage, and your home’s value rises, so your equity grows.

How to Calculate the Maximum Home Equity You Can Borrow

home value x percentage that can be borrowed – mortgage balance = maximum loan amount

To get a handle on your home equity, you’ll need to know not only the current value of your home but also how much you still owe on your mortgage. You can figure out the value of your home by looking at recent sales of similar homes in your area, getting an appraisal, or even using online tools that estimate home prices. 

Once you have those figures, subtract what you owe from what your home is worth, and voilà — that’s your equity.

Home Equity Loans infographic

As an example, if your mortgage balance is $142,500 on your house, which is currently appraised at $350,000, your home equity would be $207,500.

Your equity tells you how much of your home you actually own outright, and it’s the pot of gold you can borrow against with a home equity loan.

The Loan Approval Process

Getting a home equity loan isn’t as simple as just asking for it. Lenders are going to take a good, long look at your financials before they decide to fork over their cash.

  1. First, they’ll run your credit score, check your income, and find out how much debt you’re carrying. Generally, the better you look on paper, the better your chances of getting approved for the loan. I’ve often been told I look better on paper.
  2. Next, you must gather reams of documentation to prove you’re a minimal risk. That may include pulling out pay stubs, tax returns, and bank statements, along with the proof of home ownership and whatever other kinds of financial documents the lender wants them to see. It’s like laying down your cards at a poker game — you want to show a winning hand.
  3. When the lender has sifted through this information, it can decide how much it’s willing to lend and on what terms. It will consider how much equity you have in your home and your ability to repay, and the overall value of your home. If all that checks out, you’ll be offered a loan for the money it’s willing to lend you, the interest rate, and the repayment schedule.
  4. But don’t get too comfortable just yet. The final approval will come after an appraisal of your home and a closer inspection of your finances.

If all that passes muster, you’ll be on your merry way to getting that home equity loan, ready to put the money to work buying whatever you’ve got planned.

Typical Repayment Structure

You need to understand what you’re committing to if you’re going to borrow against the equity in your home. Many home equity loans have fixed rates of interest, which will keep your monthly payments identical over the course of the loan. That can make budgeting easier since you know exactly what you owe each month without any surprises. 

But here’s the thing: If you happen to miss one payment or, heaven forbid, default on the loan, matters will take a nasty turn. The lender can add late fees, increase your interest rate, and, even worse, start foreclosure proceedings (i.e., it will seize your home). 

While a home equity loan can be an excellent tool, it’s also an immense responsibility. Keep up with the payments, and you get to keep your house; but drop the ball, and you could find yourself being evicted from your home.

That’s why you need to be punctual with your payments and not allow things to slide. Depending on the loan, the payment schedule is usually set for a term of five to 30 years. You must plan to make monthly payments, covering both the interest accrued and a portion of the principal, until you repay the debt in full. 

Besides jeopardizing your home ownership, delinquent payments can do a tap dance on your credit score, thereby making your plight all the worse. 

How to Apply for a Home Equity Loan

Applying for a home equity loan isn’t usually a snap decision. Here is a step-by-step guide so that you can be sure you have all your ducks in a row before you start. With the right preparation, you can avoid the classic pitfalls and make the process smoother than a hot knife through butter.

Preparing Your Finances

Before you go asking for money, you need to have your own financial house in order. You want your information to be easy to access so that you can answer questions promptly and appear to know what you’re talking about.

Do yourself a favor and write down all of your financials in one place — your income, expenses, assets, and liabilities. Nothing clarifies the mind like seeing your entire financial existence organized in a spreadsheet. Frequent readers know I trust Quicken for this type of work because it has everything you need to manage your finances.

Now, take a good, long look at your credit score and financial health in general.

Your credit score, for better or worse, is your financial report card in the eyes of the lender. It shows how well you’ve managed borrowing in the past. 

You’ll also want copies of your three credit reports, available for free from Experian, Equifax, and TransUnion, to make sure they are free of any mistakes that may be dragging down your score.

If your FICO score’s looking a little rough around the edges, you may want to spend some time cleaning it up before you apply. That means paying off any outstanding debts, keeping your credit card balances low, and not taking on any new loans or credit cards right before you apply for the home equity loan. 

The healthier your credit, the better your chances of snagging a good loan with favorable terms.

Next, you will need to round up all the documents and financial records that the lender is going to want to see. If you don’t keep electronic records, you’ll have to roll up your sleeves and do a little paper wrangling.

You’ll need:

  • Pay stubs
  • Tax returns
  • Bank statements
  • Proof of homeownership
  • Anything else that shows you’re a solid bet for the lender

Consider scanning your old documents into your computer as you go through this exercise. It’s a great time to do it, and you’ll thank yourself a million times later on when you need to find something. Of course, you should couple this with specifying paperless updates on all your accounts. The trees will thank you.

When applying for a loan, you have to show your work — just like you used to in school: You must prove that you’ve got the income and assets to back up the loan. The more comprehensive you are in gathering this information, the smoother the application process will be, so it really pays not to be a slob.

Once you have all your finances in order, you’re ready to begin the process of finding the right lender to work with.

Choosing a Lender

When you’re sizing up lenders, the first things to consider are interest rates and fees. These vary from lender to lender, so don’t just pick the first one that shakes your hand. Lower interest rates mean lower monthly payments, and fewer fees mean more money in your pocket. 

You’ll want to read the fine print, as some lenders might try to sneak in extra charges where you least expect it. For example, make sure they don’t slap you with a penalty if you repay the loan sooner than expected. 

Also, consider the terms they’re offering, such as how long you’ll repay the loan and whether or not the rates are fixed or variable. You definitely don’t want to be surprised by the rate ballooning on you down the line — unless you desire that type of loan.

Tips for choosing a lender.

Next, you will want to compare several lenders once you have got the basics. Comparison shopping is not a time to be lazy — get quotes from banks, credit unions, and even online lenders. Each one may offer something a little different from the others, and it makes sense to find the best deal for your situation. 

Pay attention to their customer service, too. A lender that’s easy to work with and quick to respond to your questions can make the whole process a lot less stressful. Impatient or hard-to-reach service agents are a big red flag.

Once you have all of your options in hand, line them up side by side to see which one is best. With your lender selected, you’re one step closer to the goal line.

Completing the Application

With your finances in order and a lender selected, it’s time to finish off this fun. Get ready to make sure everything is in tip-top shape.

  1. You start by filling out the loan application, in which you will provide every last shred of personal or financial detail that the lender needs. This will include your credit history, income, debts, and the property against which you’re borrowing. Be prepared to provide the documents you’ve gathered: pay stubs, tax returns, bank statements, and all the rest. After you apply, the lender will begin mulling over your application, and this may take from a few days to several weeks, depending on the state of your finances. It may be a bit of a waiting game, so sit back and be patient. 
  2. Once the lender has your application, here is what one can expect. It will go over all your information and possibly request more documentation or clarification of items that aren’t clear. If everything checks out okay, it goes to the next step, which is ordering an appraisal of your house to make sure it’s really worth the loan amount. 
  3. Lastly, they will work out the final loan terms with you and issue a loan commitment letter that outlines all of the facts, such as the loan amount, interest rate, and repayment terms. Assuming everything is kosher, you at last reach the closing stage, where you will sign the final documents and receive your money. 

Once you’ve crossed the finish line and have your loan, it’s time to put that money to work, whether it’s fixing up your home, paying off debt, or whatever else you’ve dreamed up. But first, make sure you understand the tax rules surrounding home equity loans. 

Just remember to stay on top of your payments so you can avoid nasty headaches later on.

Benefits and Drawbacks of a Home Equity Loan

Your home equity is a gold mine, but before grabbing your pick and shovel, you need to weigh the pros and cons. A home equity loan can serve you well, but don’t let it come back to bite you.

Benefits

  • Access to Needed Money: A home equity loan lets you tap into your home’s value when that cash jar is looking mighty low. Whether you need to fix up the place, pay off some nagging debts, or cover an unexpected expense, the home equity loan lets you get your hands on a chunk of change without having to pawn off those family heirlooms.
  • Fixed Interest Rates: A fixed interest rate is a major feature of almost all home equity loans. You will not have to contend with payments suddenly shooting up like fireworks on the Fourth of July. You will know precisely what you owe each month, making it easier to budget and plan ahead.
  • Potential Tax Deductions: You may be able to deduct the interest on your home equity loan if you’re using it to “buy, build, or substantially improve” your home, according to our good buddies at the IRS. Just make sure you consult with your tax professional to see if you qualify for a little extra help from Uncle Sam.

From the IRS: “For tax years 2018 through 2025, if home equity loans or lines of credit secured by your main home or second home are used to buy, build, or substantially improve the residence, the interest you pay on the borrowed funds is classified as home acquisition debt and may be deductible, subject to certain dollar limitations. However, interest on the same debt used to pay personal living expenses, such as credit card debts, is not deductible.”

Drawbacks:

  • Risk of Foreclosure: The biggest risk, if you cannot make your payments, is that the lender can foreclose on your home. When using your home as collateral, you must ensure that you can continue paying your mortgages — first and second — if you want to keep it.
  • Credit Score Impact: Try not to miss even one payment on your home equity loan since that dings your credit score. A payment overdue by 30 or more days could send your score tumbling and make it harder to get future loans. If your credit is already a bit wobbly, take extra precautions to ensure you pay up on time.
  • Owing More Than the Worth of Your Home: If the housing market nosedives, you may end up owing more on your loan than your home is worth — it can feel like you’re stuck in quicksand. This is called “being underwater,” and it will put you in a real bind if you need to sell or refinance.

A home equity loan is a powerful tool, but it is not without its risks. Weighing the pros and cons like a prudent shopper will tell you if it is indeed right for you.

Alternatives to Home Equity Loans

Sometimes, when you’re looking for cash, you’ve got to think outside the box. Sure, a home equity loan may seem like the easy way out. Still, it’s always good to know what other trails you can explore first, such as HELOCs and personal loans, before you hitch your wagon to one option.

Home Equity Lines of Credit (HELOCs) 

A home equity line of credit, or HELOC, is a handy-dandy source of credit that’s always there when you need it. Unlike a home equity loan, in which you get the whole lump sum at one time, a HELOC works more like a credit card. 

You borrow what you need when you need it and only pay interest on the amount you’ve actually used. It’s a revolving line of credit that’s secured by the equity in your home, which means you can borrow and repay and borrow again.

The real beauty of a HELOC is how flexible it is.

Home Equity LoanHome Equity Line of Credit
Type of InterestFixed-rateVariable-rate
Repayment Term5-15 years15-20 years
PayoutLump sumRevolving credit
Type of LoanSecuredSecured
Best For…Debt consolidation, major renovation costsMinor renovation costs over a number of years

You can borrow a little here or there, maybe for ongoing home repairs or unplanned expenses, and you’ve got a longer time to pay it back compared to a traditional loan. HELOCs often have adjustable mortgage rates. The interest rates may start off lower than a fixed-rate home equity loan, although they can rise over time, so you’ve got to keep an eye on that.

Personal Loans

If you’re not too keen on using your home as collateral, you may prefer a personal loan. It is an unsecured loan, so the bank cannot come after your home if, for some reason, things go awry and you miss a payment. That can be a real comfort, like having a safety net under you when you’re walking a tightrope. 

Unsecured personal loans may be a much better option for you if you need a small sum of money or are looking for a quicker approval process. Sometimes, personal loans have more favorable rates or terms, especially if your credit is solid. It’s like choosing the right tool for the job — sometimes, a hammer works better than a piledriver.

Credit Cards and Other Financing Options 

Now, credit cards may not be the first financing tool that jumps to mind when you’re thinking about big expenses. However, the right card, with a high enough limit and relatively low interest rate, can be an easy, efficient way to handle smaller expenses without all the hassle of a loan application. 

Remember that credit cards can get you into hot water faster than a tea kettle on high if you haven’t been responsible with your spending. Interest rates are usually sky-high if you don’t repay your balance by the due date.

If a credit card doesn’t sound like a good fit, there are other kinds of loans, such as cash-out refinancing. This is where you replace your current mortgage with one that’s higher and get the difference in cash. It can be a good option if the new rate is lower than your current one. 

Keep in mind, you are resetting the clock on your mortgage, which means you could be paying it off longer. Other options include personal lines of credit, which are similar to HELOCs but don’t require your home as collateral. 

All of these options have their own special twists, and the best choice depends on your individual situation. It’s much like the type of bait you need when you go fishing; you need to choose the best one that serves your needs and gets the job done for the least cost.

Home Equity Loans Can Give Homeowners Flexibility

A home equity loan can free up the sort of financial elbow room that’s as comfortable as a well-worn pair of slippers. You can handle those big projects, consolidate debt, or whatever comes your way without working up a sweat. 

But I would caution you to remember that it’s your home on the line. So, don’t get too carried away with all that newfound flexibility.