A home equity loan is a type of loan in which a homeowner borrows against the equity in their property, using the home as collateral. Equity is the difference between the home market value and the outstanding mortgage balance. The loan provides a lump sum at a fixed interest rate, with repayment over a set term (typically 5 to 30 years). Defaulting on a home equity loan can lead to foreclosure.
Key Takeaways
- A home equity loan lets you borrow against the equity in your property, up to about 80 to 85 percent of combined loan-to-value.
- It provides a lump sum at a fixed rate, with predictable monthly payments.
- It is distinct from a HELOC (Home Equity Line of Credit), which is a revolving line at a variable rate.
- Interest may be tax-deductible if the funds are used to buy, build, or substantially improve the home.
- Default can result in foreclosure, making these loans riskier than unsecured debt.
What is a Home Equity Loan?
A home equity loan is a second mortgage. The lender places a lien on the property, behind the first mortgage. The borrower receives a lump sum up front and repays it in equal monthly installments over the loan term. The fixed rate and fixed term make budgeting straightforward. Loan amounts typically range from 10,000 to 500,000 dollars, depending on the equity available.
For example, a homeowner with a home valued at 400,000 dollars and a first mortgage balance of 200,000 dollars has 200,000 dollars in equity. At an 80 percent combined loan-to-value limit, the total mortgage debt allowed (first plus second) is 320,000 dollars. Since the first mortgage is 200,000 dollars, the homeowner can borrow up to 120,000 dollars in a home equity loan.
How Does a Home Equity Loan Work?
The process begins with an application, credit check, and home appraisal. Lenders typically require a credit score of at least 680, a debt-to-income ratio below 43 percent, and combined loan-to-value (CLTV) below 80 to 85 percent. The appraisal establishes the home current market value, which sets the borrowing ceiling.
Once approved, the borrower receives the lump sum at closing. Repayment terms are 5, 10, 15, 20, or 30 years. Interest rates in 2024 typically range from 7 to 9 percent for borrowers with good credit, about 1 to 2 percentage points above the prime rate.
The loan is structured as an amortizing loan: each payment covers both interest and principal. In the early years, most of the payment is interest. By year 15 of a 30-year loan, the split is roughly equal. Once the loan is fully repaid, the lien is released.
Why Does a Home Equity Loan Matter?
Home equity loans matter because they give homeowners access to low-cost borrowing. The collateral (the home) reduces lender risk, so rates are several percentage points below credit cards, which charge 20 to 29 percent in 2024. A homeowner can consolidate 30,000 dollars in credit card debt at 25 percent into a home equity loan at 8 percent, saving thousands of dollars in interest.
They also fund major investments: home renovations that increase property value, education expenses, or small business capital. The Tax Cuts and Jobs Act of 2017 changed the deductibility rules: interest is deductible only if the loan proceeds are used to buy, build, or substantially improve the home securing the loan. Using the funds to pay off credit cards or student loans no longer qualifies.
For lenders, home equity loans are profitable products with relatively low default rates. During the 2008 crisis, second-lien losses were severe, but post-crisis underwriting has been much stricter. Default rates on home equity loans in 2023 were under 2 percent, according to the American Bankers Association.
What Are the Limitations of a Home Equity Loan?
- Foreclosure risk - default on a home equity loan can lead to foreclosure, even if the first mortgage is current. The second-lien holder can initiate foreclosure or pay off the first lien and foreclose themselves.
- Reduced equity cushion - taking out a home equity loan reduces the buffer between home value and debt. If home prices fall, the homeowner may end up underwater (owing more than the home is worth).
- Closing costs - like a first mortgage, home equity loans have closing costs (appraisal, title search, origination fee), typically 2 to 5 percent of the loan amount.
- Less flexibility than a HELOC - a home equity loan is a lump sum. If you only need 10,000 dollars now and 10,000 dollars next year, a HELOC lets you draw as you go, paying interest only on the amount drawn.
- Tax deductibility restrictions - only funds used for home acquisition or improvement are deductible. This reduces the tax advantage for borrowers using the funds for debt consolidation or other purposes.
Frequently Asked Questions
What is the difference between a home equity loan and a HELOC?
A home equity loan is a lump sum at a fixed rate, with a fixed repayment schedule. A HELOC is a revolving line of credit at a variable rate, similar to a credit card. With a HELOC, you can borrow, repay, and borrow again during the draw period (typically 10 years), then enter a repayment period.
How much can I borrow with a home equity loan?
Most lenders allow a combined loan-to-value (CLTV) of 80 to 85 percent. Subtract your first mortgage balance from 80 to 85 percent of your home value to estimate the maximum you can borrow. Some lenders go to 90 percent CLTV for well-qualified borrowers, but at higher rates.
Is a home equity loan the same as a second mortgage?
Yes. A home equity loan is a second mortgage because it is secured by your home and is subordinate to the first mortgage. In the event of foreclosure, the first mortgage is paid first, and the home equity loan holder is paid from any remaining proceeds.
This article is for educational purposes only and does not constitute financial advice.
