What Is A Home Equity Loan And How Does It Work?

How does a home equity loan work?

As home values increase, so does the amount of equity available to homeowners. But home equity isn’t liquid wealth; the money is tied up in your home. To access your home’s value, you either need to sell or take out a loan against the property.

One option is a cash-out refinance, which lets you tap equity and refinance your existing loan, sometimes to a lower rate.

But what if you’re happy with your current mortgage? Another option is a home equity loan, or ‘second mortgage,’ which lets you cash out without a full refinance. Here’s what you need to know.

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What is a home equity loan?

A home equity loan is a type of mortgage, often called a second mortgage or a home equity installment loan, that lets you draw on your home equity by borrowing against the home’s value.

Unlike a cash-out refinance, a home equity loan lets you tap your home’s cash value without touching your current home loan. So if you’re already happy with your mortgage payment and interest rate, or you’re almost finished repaying the original loan, you can leave its terms intact.

This type of loan can also help homeowners who own their homes outright and don’t want to refinance the entire home value just to access equity.

How does a home equity loan work?

Home equity loans are mortgages, and they’re just like your original home loan. They are secured by your property which means that if you don’t make your loan payments, you can lose your house to foreclosure. Just like you can with a “regular” mortgage.

A home equity loan can be structured to deliver a lump sum of cash at closing, or as a line of credit that can be tapped and repaid, kind of like a credit card. The second type is known as a home equity line of credit (HELOC).

If you have a fixed-rate loan (this is the norm), you’ll make equal monthly payments over the loan’s term until it’s paid off.

The fixed rate and payment make the home equity loan easier to include in your budget than a HELOC, whose rate and payments can change over the course of the loan.

A home equity loan can be a good idea when you need the full loan amount at once and want a fixed interest rate.

For example, if you wanted to consolidate several credit card accounts into a single loan, or if you needed to pay a contractor upfront for a major home renovation, a home equity loan could be a great choice.

How much can you borrow with a home equity loan?

The amount of money you can borrow through a home equity loan depends on your creditworthiness and the value of your home.

Since the home is used as collateral, how much cash a homeowner can access is partly based on the combined loan-to-value ratio (LTV) of their primary and second mortgage. As a rule of thumb, the amount you owe on your primary home loan and home equity loan combined can’t be more than 75% to 90% of your home’s appraised value.

The amount of money you can borrow and the interest rate are also determined by the health of your credit report.

To find your possible loan amount, start by subtracting the amount you owe on your existing mortgage from the market value of your home. For example, if your home is valued at $300,000 and you owe $150,000 on your existing mortgage, you own the remaining $150,000 in home equity.

Most of the time you can’t borrow the full amount of equity, but you may be able to tap 75% to 90% of it.

In the example above, that means you could likely borrow between $112,500 and $135,000, minus closing costs.

You could use this money for home improvements, debt consolidation, or to make a down payment on a vacation home or real estate investment property.

Home equity loan interest rates

When you apply for home equity financing, expect higher interest rates than you’d get on a first mortgage due to the extra risk these loans pose for lenders.

Fixed home equity interest rates for borrowers with excellent credit are about 1.5% higher than current 15-year fixed mortgage rates.

Home equity interest rates vary more widely than mainstream first mortgage rates, and your credit score has more impact on the rate you pay. For example, an 80-point difference in FICO credit scores can create a 6% difference in home equity interest rates.

Home equity lines of credit (HELOCs) have variable interest rates. This means your monthly payment depends on your loan balance and the current prime rate. Your payment and rate can change from month to month.

Home equity loans can have variable interest rates, but most of the time the rate and payment are fixed.

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

The home equity line of credit, or HELOC, offers more flexibility than a home equity loan. But it makes budgeting harder.

HELOCs have a “draw period” in which you’re allowed to tap the loan amount up to your credit limit. You can withdraw and repay funds as needed during these first years.

There is a minimum payment — usually the amount needed to cover the interest due that month. At any given time, you pay interest only on the amount of the balance you use.

When the draw period ends, you can no longer tap the credit line and must repay it over a predetermined number of years. With its variable interest rate, your payment could change every month.

Some HELOCs allow you to fix your interest rate when you enter the repayment period. These are called “convertible” HELOCs.

HELOCs are ideal loan options for expenses that will be spread over a longer period of time, or as a source of emergency cash.

For instance, you might take a HELOC to serve as an emergency fund for your business. Or you could use it to pay college tuition twice a year. HELOCs are also helpful for home improvements that take place in stages over an extended period of time.

How second mortgages work

If you’re considering a home equity loan or home equity line of credit, it’s important to understand how these second mortgages work.

One important point is that you keep your existing mortgage intact. You continue making payments on it as you’ve always done.

The home equity loan or HELOC is a second, separate loan with additional payments due each month. So you’d have two lenders and two loans to make payments on.

Second mortgages are riskier than first mortgages

The primary mortgage lender gets paid first if a loan defaults and the home is sold in foreclosure. The second mortgage lender — which holds the home equity loan or HELOC — may get paid less than it’s owed. Or it may not get paid at all. (A second mortgage lender is also known as a “junior lien holder.”)

Due to this extra risk, home equity loans charge higher interest rates than a primary mortgage. A cash-out refinance might come with lower rates.

Home equity loans are also a bit harder to qualify for. You’ll typically need a credit score of at least 680-700 for a home equity loan, as opposed to 600-620 for a cash-out refi.

A home equity loan can be a smart way to access the cash value you’ve built up in your home, especially if you invest that lump sum of cash into other real estate opportunities or home renovations that increase the value of your home. Still, you can end up owing more than your property is worth if real estate values drop.

More differences between first and second mortgages

Besides the interest rate, there are a few other distinctions between first and second mortgages. Second mortgages have:

• Shorter loan terms: Home equity loans and lines of credit can have terms ranging from 5 to 20 years, with 15 years being the most common. The shorter repayment time reduces the risk to lenders
• Smaller loan amounts: Many first mortgage programs allow you to finance 95%, 97%, or even 100% of your home’s purchase price. Most home equity lenders max out your loan-to-value at 80% to 90% of your equity
• Lower fees: While some still charge origination fees, HELOC lenders, for example, often absorb most or all of the fees. Home equity loan fees for title insurance and escrow are usually much lower than those for first mortgages
• Faster processing: Home equity loans usually close much faster than first mortgages. You may get your money in a couple of weeks, as opposed to 1-2 months

Also, your second mortgage lender may not require a full appraisal. This could save hundreds of dollars in closing costs compared to getting a first mortgage.

Cash-out refinance vs. home equity loan

Home equity loans and HELOCs aren’t the only ways to borrow against the cash value of your home.

Some homeowners prefer a cash-out refinance loan, which has a few advantages:

• Single loan: Since cash-out refinancing replaces your existing mortgage while also unlocking equity, you’d have only one mortgage loan instead of two
• Lower interest rates: Cash-out refinance rates are typically lower than home equity loan or HELOC rates. In addition, since you’d be replacing your existing mortgage with a new mortgage, all of your home debt could potentially be re-cast at a lower interest rate
• Opportunity to pay off the house early: Shorter loan terms require higher loan payments each month, but they can save a lot in interest charges over the life of your loan. A cash-out refinance offers an opportunity to shorten your current loan term from a 30-year fixed to a 15-year fixed mortgage, for example

Cash-out refinancing isn’t for everyone. If your first mortgage is almost paid off, for example, you’re probably better off with a second mortgage.

If your existing mortgage rate is already near today’s rates, your savings from refinancing might not eclipse the closing costs and other borrowing fees. In that case, a second mortgage is probably the way to go.

Other alternatives to home equity loans

If you recently bought or refinanced your home, you may not have enough equity built up to warrant a second mortgage or a cash-out refinance just yet.

In this case, you’ll need to wait until your home’s market value increases and your original mortgage balance decreases, generating enough equity to qualify for a new loan from a bank or credit union.

But what if you need cash sooner? You may want to consider:

Personal loans

Personal loans do not require backing from home equity. They are ‘unsecured’ loans, requiring only a high enough credit score and income to pay back the loan.

Since the loan is not secured against your property as collateral, interest rates are much higher.

You can often find personal loan amounts up to $100,000, but if you have bad credit or a high debt-to-income ratio, you’ll have limited options.

Applicants with excellent credit histories have more loan options, but since personal loans require no collateral, they can’t compete with the low interest rates you’d get on a secured mortgage.

And unlike a mortgage, the interest you pay on a personal loan is not tax-deductible, even if you use the loan to fund home improvements.

Credit cards

With their annual fees and high annual percentage rates, credit cards should be a last resort for long-term borrowers — unless you can get a no-interest credit card and pay it off before the promotional rate expires.

If a credit card offers a 0% APR for 18 months, for example, you may be able to keep the card balance until you’re able to get a second mortgage loan to pay off the card. If you time it right, you’ll avoid the credit card’s punitive charges.

However, this is a risky strategy. If you don’t have enough equity or a sufficient credit score to qualify for a cash-out mortgage now, it could be difficult to improve your financial situation enough to get one before the credit card promotion expires. This could land you with high credit card debt and no good way to pay it off.

What are today’s home equity mortgage rates?

As noted above, home equity loan rates are more sensitive to your credit history than first mortgages. Rates can also vary more between lenders, which makes it important to shop for a good deal.

To get an accurate quote, you’ll need to provide an estimate of your credit score and your property value.