How Do Home Equity Loans Work? Understanding Borrowing, Costs and Benefits

A home equity loan lets you borrow against your home's value, using it as collateral to secure a lump sum of cash. Unlike credit cards or personal loans, home equity loans typically offer lower, fixed interest rates because your home guarantees repayment.

If you're wondering how home equity loans work, we'll explain the borrowing process, repayment terms and costs so you can determine if it's right for your financial needs. We'll also cover how much you can borrow and when a home equity loan might make sense for you.

Key Takeaways

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Home equity loans offer fixed interest rates and lump-sum payments, providing predictable monthly payments and long-term stability but tying your home to the loan.

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Paying down your mortgage and making home improvements can increase equity, boosting the amount you can borrow or improving your eligibility for a loan.

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Alternatives like HELOCs offer flexible credit, while personal loans don’t use your home as collateral, making them safer for smaller, short-term needs.

Features and Benefits of Home Equity Loans

Understanding how home equity loans work is important because they impact your monthly payments and total loan cost. These loans come with specific features that set them apart from other types of borrowing. Here are the main features you should know:

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    Fixed interest rates

    Your rate stays the same for the entire loan, offering predictable monthly payments.

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    Lump-sum disbursement

    You receive the full loan amount upfront, which is helpful for significant expenses like home renovations.

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    Repayment terms and timeline

    Typically lasting five to 30 years, you pay the loan back over a set period with consistent payments.

What Can You Use a Home Equity Loan For?

Knowing what you can use a home equity loan for is essential — using it for the wrong reasons can lead to financial strain. For example, using the loan to fund a lavish vacation or buy luxury items might feel rewarding in the short term, but it leaves you with debt tied to your home. If you struggle to make payments, you could risk losing your property. Here are some common ways to put a home equity loan to good use:

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    Home improvements

    Upgrading your home can increase its value, offering a potential return on investment when you sell.

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    Debt consolidation

    Paying off high-interest debt with a lower-rate loan can simplify your finances and reduce overall interest costs.

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    Education expenses

    Using home equity for college tuition can be cheaper than private student loans.

    Emergency medical expenses

    Covering large, unexpected medical bills can help ease financial stress in challenging times.

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    Business investments

    Starting or expanding a business with home equity funds may lead to future income growth, though it carries some risk.

How to Calculate Home Equity

Amala, a homeowner, is curious about tapping into her home equity for renovations. Before applying for a loan, she needs to know how to calculate home equity. By following these simple steps, Amala can determine how much equity she has:

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    Find your home’s current market value

    Amala checks recent sales of similar homes in her neighborhood or gets a professional appraisal to estimate her home’s value.

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    Subtract your outstanding mortgage balance

    Amala looks at her mortgage statement and subtracts what she still owes from her home’s value. From the appraisal, she learns it is worth $300,000. Since she still owes $150,000, her equity is $150,000.

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    Determine if you meet lender requirements

    With $150,000 in equity, Amala meets most lender requirements, which is at least 20% equity. Her loan-to-value ratio (LTV) is 50%, well below the 80% threshold many lenders look for when approving home equity loans.

Most lenders have other home equity loan requirements besides the home equity and loan-to-value (LTV) ratio. For example, they’ll typically expect a credit score of 620 or higher, though some may require better scores for larger loans.

Lenders also look at your debt-to-income (DTI) ratio, usually requiring it to be below 43%, and your employment history to ensure stable income. Meeting these requirements improves your chances of approval and helps you secure better loan terms.

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How to Increase the Home Equity

Building home equity over time can give you more borrowing power and financial flexibility. Whether you plan to sell or tap into a loan, increasing your equity is always smart. Here are some effective ways to boost it:

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    Pay down your mortgage

    The more you pay off your mortgage principal, the larger your share of home ownership becomes, increasing your equity.

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    Make home improvements

    Renovations that add value, like updating kitchens or bathrooms, can boost your home’s market value, increasing your equity.

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    Refinance to a shorter loan term

    By switching to a 15-year mortgage, you pay off your loan faster and build equity more quickly.

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    Wait for property values to rise

    Over time, market appreciation can naturally increase your home’s value, boosting your equity without you needing to take any immediate action.

How Much Can You Borrow With a Home Equity Loan?

Lenders typically allow you to borrow up to 80% to 90% of your home’s equity. To find out how much you can borrow, you can do a quick calculation based on your home’s value and mortgage balance.

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    Determine your home’s current value

    Let’s say your home is valued at $400,000. You can use an appraisal or market research to estimate this.

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    Calculate 80% of your home’s value

    Multiply your home’s value by 0.80 to find what lenders might let you borrow. In this case, 80% of $400,000 is $320,000. If your lender allows up to 90% of your home’s value, multiply $400,000 by 0.90.

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    Subtract your outstanding mortgage balance

    If you still owe $150,000 on your mortgage, subtract that from $320,000. This leaves you with $170,000 as the amount you can borrow.

Just because you can borrow up to $170,000 doesn’t mean you’ll automatically qualify for the full amount. Lenders also consider other factors, such as your credit score, debt-to-income ratio and employment history. For instance, if your debt-to-income ratio is too high or your credit score is below their preferred threshold, they may reduce your loan amount.

Home Equity Loan Repayment and Costs

Your mortgage rate plays a big role in the cost of your home equity loan. With a fixed interest rate, you'll make consistent monthly payments over the life of the loan, which helps with budgeting. However, the higher your mortgage rate, the more you'll pay in interest over time.

In addition to interest, there are other costs like origination fees and closing costs, ranging from 2% to 5% of the loan amount. These fees are usually rolled into your loan, increasing the total cost you'll need to repay.

When (and When Not) to Use a Home Equity Loan

Understanding how home equity loans work includes knowing when they’re a smart option and when they could lead to trouble. Borrowing against your home’s equity can be helpful in certain situations, but it’s not always the right choice. Here’s a breakdown of when it’s a good idea — and when it’s not:

When It’s a Good Idea
When It’s Not

Home improvements that add long-term value, like a kitchen remodel, which can increase your home's resale price.

Funding a vacation or luxury items that don’t offer any return on investment but leave you with long-term debt.

Consolidating high-interest debt like credit cards reduces your overall interest payments and simplifies finances.

Paying off short-term debts that could be managed without putting your home at risk, like a small personal loan.

Covering education costs with lower rates compared to student loans, especially for long-term career growth.

Using it for risky investments, such as stocks or starting a business, where the return is uncertain.

Paying for emergency medical expenses that would otherwise lead to high-interest debt, ensuring financial stability.

Borrowing when your income is unstable, which increases the risk of defaulting and potentially losing your home.

Alternatives to Home Equity Loans

A home equity loan might not always be the best fit, especially if you need more flexibility or want to avoid borrowing against your home. There are other financing options worth considering. Here are some home equity loan alternatives and when they might be a better choice:

Alternative
What It Is
When It’s a Better Option

A line of credit using your home’s equity with variable rates.

When you need flexible access to funds over time instead of a lump sum.

Replaces your mortgage with a new loan for a larger amount, cashing out the difference.

When mortgage rates are low, and you want to consolidate your loan and equity in one payment.

Unsecured loan with fixed payments, not tied to your home.

When you need a smaller loan and don’t want to risk your home as collateral.

Revolving credit with higher interest rates but no collateral.

When covering short-term, smaller expenses that you can pay off quickly.

Loan for homeowners 62 or older, turning home equity into income, though there are some risks.

When you’re older and need ongoing cash flow without having to repay a loan until you move or sell.

FAQ: How Home Equity Loans Work

If you’re still wondering how home equity loans work or if they’re right for you, these common questions might help clarify things. We answered some frequently asked questions about home equity loans, from how they compare to HELOCs to what happens if you can’t repay the loan.

How do home equity loans work compared to HELOCs?

How long does it take to get approved for a home equity loan?

Can I use a home equity loan for anything I want?

What happens if I can't repay my home equity loan?

Does a home equity loan affect my mortgage?

Is the interest on a home equity loan tax-deductible?

Can I get a home equity loan if my credit score is low?

About Zachary Romeo, CBCA


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Zachary Romeo is a certified Commercial Banking and Credit Analyst (CBCA), and the Head of Loans and Banking at MoneyGeek. Previously, he led production teams for some of the largest online informational resources in higher education, with over 13 years of experience in editorial production.

Romeo has a bachelor's degree in biological engineering from Cornell University. He geeks out on minimizing personal debt and helping others do the same through people-first content.