How does a home equity loan work?

Buying a home is more than an investment in future wealth. You could also use the equity you've built to help reach your financial goals now, without needing to sell your home. 

As you pay down your mortgage or your home's value increases, your home equity grows. That equity could be the ticket to big borrowing power.

A home equity loan is a way to borrow using your home as collateral (security), typically with a fixed interest rate, which means predictable monthly payments over a set repayment term. The amount you could borrow depends on your available equity and your overall financial situation.

The home equity loan process

Most home equity loans follow a similar structure:

• You apply for the loan.

• The lender reviews your home equity, credit, income, and existing debts.

• If approved, you receive the full loan amount as a lump sum.

• You repay the loan with fixed monthly payments for the length of the loan term.

• Once the loan is repaid, the account is closed.

Some of the finer points may vary by lender, but the overall process is fairly typical. Here are some of the important parts in more detail:

• How equity is calculated. Lenders typically conduct an appraisal or digital valuation to determine your home’s current value. Lenders then subtract your mortgage balance from that value to determine your home equity.

• How much you may be able to borrow. Your borrowing limit largely depends on the total debt you’ll have against your home, or the combined loan-to-value (CLTV) ratio. Most lenders set their limits around 80% to 90% of the home’s value. The combined total of the original mortgage and the home equity loan has to stay within this limit.

• How you receive the money. You receive a single lump-sum payment from the lender, usually through direct deposit to your bank account. Some lenders also offer other options, such as checks.

• How repayment works. Home equity loans have a fixed payment amount and a fixed term. With most home equity loans, you make equal monthly payments until you’ve paid off the balance and interest. Typical home equity loans have terms of five to 30 years.

Home equity loan example

Understanding how an equity loan works starts with knowing how lenders calculate your available equity and borrowing limit. Here’s an example:

If your home is worth $300,000 and you owe $180,000, then you have $120,000 in home equity.

Here’s the simple calculation for home equity:

$300,000 - $180,000 = $120,000

Now, here’s how to estimate the size of a home equity loan you could take out. Let’s say the lender has an 80% CLTV limit. That means 80% of your home’s value is $240,000:

$300,000 x 0.80 = $240,000

Since you already have a mortgage balance of $180,000, that leaves $60,000 available for a home equity loan:

$240,000 - $180,000 = $60,000

In this scenario, you could potentially get a home equity loan for up to $60,000. Other factors could also influence your limit, including the lender's loan cap, your credit history, and your debt-to-income (DTI) ratio.

What can you use a home equity loan for?

You could use a home equity loan for almost any purpose allowed by your lender. Common uses include:

• Paying off high-interest debts

• Funding a home remodel

• Covering a major purchase

You may enjoy an extra benefit if you use your home equity loan to fund major home improvements or remodels. Interest paid on a home equity loan could be tax-deductible in some cases. Consult a tax professional to learn more about potential tax impacts.

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Home equity loan vs. HELOC

A home equity line of credit (HELOC) is another way to borrow against your home equity. While both HELOCs and home equity loans use your home as collateral, they work very differently. 

A home equity loan provides the full loan amount upfront, and you repay with fixed monthly payments from the start. A HELOC is a revolving line of credit. You can borrow, repay, and borrow again up to your credit limit during a set draw period.

Here’s a HELOC vs. home equity loan comparison:

A home equity loan is typically the more predictable option with its fixed payments and interest rate, making it ideal for large one-time expenses.

A HELOC could provide more flexibility since you can borrow again as you repay it during the draw period, and it could work well for projects with ongoing costs, such as home remodels.

Home equity loan repayment

You repay a home equity loan much like a mortgage. You make fixed monthly payments by the due date for the length of the loan until the balance is paid off. Your lender might give you the option to enroll in automatic payments, which could help you snag a rate discount or other benefits. 

Here’s an example of how home equity loan repayment works for different term lengths. Let’s say you get a $50,000 home equity loan with a 10% interest rate:

Use a home equity loan payment calculator to estimate your potential monthly payment and explore your loan options.

How long do you have to pay back a home equity loan?

Terms on home equity loans typically range from five to 30 years. When you apply, your lender can tell you which repayment terms are available and help you choose an option that fits your budget.

Longer terms could lower your monthly payments but typically cost more in interest over time. Choose a term that balances affordability with overall cost.

Home equity loan pros and cons

Here are some of the biggest pros and cons of home equity loans:

Pros

• Turn home equity into cash

• Predictable fixed payments and terms

• Often lower interest than unsecured options

• Wide range of repayment terms available

Cons

• Closing costs, typically 0% to 6% of the loan amount

• Reduced home equity

• Risk of foreclosure if you can't repay the loan

• Less flexible than HELOCs

Is a home equity loan a good idea?

A home equity loan could be a good option if you have built up enough equity in your home and can comfortably afford the monthly payments. Whether it’s the right choice depends on factors such as your:

• Credit score

• Income and existing debts

• Reasons for borrowing

A fair to good credit score could make it easier to get approved for a home equity loan and get a lower interest rate. A steady income and manageable existing debt might also work in your favor.

Home equity loan from Achieve Loans

Achieve Loans offers a home equity product that combines features of traditional home equity loans and HELOCs. Achieve Loans offers a draw period and a fixed interest rate. Here are a few other features to know about:

• Customizable term and payment schedule

• Fast funding

• Loans up to $300,000

• Potential interest rate discount if you enroll in autopay

• Refinance not required if you want to keep your current mortgage terms

If you're interested in learning more, check your options with no credit impact. It doesn't take long, and you can find out if a home equity loan through Achieve Loans is a good fit for your financial needs.