How does a home equity loan work?

By Betsalel Cohen

Reviewed by Kimberly Rotter

Jan 30, 2023

Read time: 7 min

How does a home equity loan work

Key Takeaways:

  • Home equity loans are mortgages that allow you to borrow a lump sum against your home’s equity.

  • Home equity loans have fixed interest rates, and the monthly payment will be the same for the life of the loan. 

  • A fixed-rate HELOC might be a better option because you can borrow and repay repeatedly for the first few years (like a credit card), but with the benefit of a fixed interest rate (like a home equity loan). 

Got equity? If you’ve been paying down your mortgage or your neighborhood has gone up in value, or both, you might be able to use a home equity loan to cover a large expense. 

What is a home equity loan?

A home equity loan is a way to borrow against your home to finance a large expense and pay for it over a longer period of time compared to personal loans.

A home equity loan is a mortgage, and mortgages are secured loans. Most people explain what that means by letting you know that the lender can sell your house if you fail to repay the loan. That’s true. But there’s a bright side. Because they are secured by your home, mortgages and home equity loans offer some of the best terms you can get when you need financing. 

What is a home equity loan made of?

Your equity

Before you can consider a home equity loan, you need to know whether you have enough equity to qualify. 

Equity is simple. It’s your home’s current market value minus the amount you owe on your mortgage. The lender will hire a professional appraiser to find out the market value, but in the meantime, you can check Zillow or Redfin to get a ballpark. 

If your home is worth $500,000 and you still owe $200,000 on your mortgage, you have 60% equity. (On a calculator, subtract what you owe from the value, then divide the result by the value.)

Does this mean that you can borrow $300,000? Not exactly. We’ll break this down in the next section.

The lender’s loan limit

Lenders don’t just look at the dollar amount of equity you have in your home. Most lenders also limit the percentage of your home’s value that they will loan. This is the loan-to-value ratio (LTV) or combined loan-to-value ratio (CLTV). 

LTV is the opposite of equity. If you owe $200,000 on a $500,000 home, the LTV is 40%. 

Most lenders allow you to borrow up to 80-85% of the value. But that limit includes all outstanding mortgage debt—your current mortgage plus the home equity loan that you want. 

Using the above example, if the lender allows for an 80% combined loan-to-value, you can borrow up to $200,000 on your home equity loan.

Besides the LTV limit, lenders have a maximum dollar amount they will loan. Also, the lender will review your credit and income.

A lump sum

You apply to borrow a lump sum, and you get the entire amount in your bank account when your loan closes. You cannot change the loan amount later, even if you decide that you need more money, or that you didn’t need so much.

Repayment starts right away.

Fixed interest rate

Generally, home equity loans have a fixed interest rate. It’s locked in when your loan is approved. Your payment amount won’t change for the life of the loan. Even if economic conditions change, the rate on a fixed-rate loan will remain steady. 

Closing costs

Like other mortgages, home equity loans come with closing costs. These include origination fees, underwriting fees, and appraisal fees. Closing costs can be 2-5% of your loan amount.

Length (term) and monthly payment

Home equity loans usually have a longer repayment period (term) compared to personal loans, usually 10 to 20 years. 

Sometimes you can choose your loan term. With a shorter term, you will have a higher monthly payment, but you will save money on interest charges. You can go with a longer loan term for a lower payment, but you will pay more over the life of the loan.  

How to use your home equity loan

A home equity loan offers a lot of flexibility, as the money can be used for almost anything. Here are some examples of how a home equity loan may help you:

Pay off debt

If you have a lot of credit card debt, medical debt, or other debt, you can pay it off with a home equity loan. Debt consolidation can simplify your finances by reducing many monthly payments down to one. Also, you might be able to lower the interest rate, especially if your debt is on high-interest credit cards.

Make home improvements or repairs

A home equity loan is a great option for costly home improvements and repairs. You could use one to update your kitchen or bathroom or to fix or replace your roof, HVAC system, or floors.

Pay for college expenses

Tuition, housing, books, rent, food... Getting an education can be expensive. Grants and scholarships can be hard to come by, and student loans aren’t available to everyone. A home equity loan can be an affordable alternative to cover these costs.

Pay for a large expense

Home equity loans tend to have higher limits than personal loans, and more time to repay. So if you have a large expense, it might make sense to finance it this way. Some people use a home equity loan for a wedding, new electronics, new appliances, or to cover an unexpected emergency.  

Home equity loan vs home equity line of credit (HELOC)

A home equity loan is a one-time loan. A HELOC allows you to borrow, repay, and borrow more, up to your loan limit, during the first few years. 

Although both types of financing depend on your home equity, there are some key differences.

Draw period. HELOCs have a draw period and work sort of like credit cards at the beginning. You can borrow, make payments, and borrow more as often as you like, up to your maximum loan amount. When your HELOC draw period ends, your repayment period begins, and you can’t borrow any more. With a home equity loan, you get all of the money when the loan closes.

Fixed interest rate. Most home equity loans have a fixed interest rate that never changes after your loan closes. In contrast, most HELOCs have a variable interest rate, which means your rate can change as the economy changes. 

Monthly payment. The payment on a variable-rate HELOC can be hard to manage. First, some lenders only require interest payments during the draw period. That means your monthly payment will spike when it’s time to begin repayment. Second, when interest rates fluctuate (and they do), so does your cost. On a home equity loan, the payment is the same from the first month to the last.

Future cost. On a variable-rate HELOC, there’s no way to predict what interest rate you’ll pay in a few years when the draw period ends and you enter repayment.

How the Achieve home equity loan works

Achieve offers a unique home equity loan that blends the best features of traditional home equity loans and HELOCs. Our loan has both a draw period and a fixed interest rate. Here are a few other features you should know about:

  • You can apply if your credit score is 640 or higher

  • You can customize your term and payment schedule

  • Loans close in as little as 14 days

  • Loans up to $150,000 are available

  • You can get an interest rate discount if you enroll in autopay

It’s a big decision. That’s why we make professional mortgage advisors available to anyone who’s interested in learning more. They’ll help you understand your choices, including how much you could save with each option. If you’re looking for debt consolidation, we won’t recommend a loan unless it will save you at least $200 a month. Achieve is committed to helping you make the best decision, even if it means going with an option that we don’t provide. 

Learn more about the Home Equity Loan offered through Achieve.

Betsalel Cohen - Author

Betsalel is a contributing writer for Achieve. Passionate about helping people improve their finances. He worked in mortgage banking, private banking, and personal financial coaching. When he is not working, he loves running and spending time with his family.

kim rotter 2022 2

Kimberly is Achieve’s senior editor. She is a financial counselor accredited by the Association for Financial Counseling & Planning Education®, and a mortgage expert for The Motley Fool. She owns and manages a 350-writer content agency.

Frequently asked questions

Yes, although most HELOCs have a variable interest rate, some lenders offer HELOCs with a fixed-rate option. The interest rate won't change over the life of the loan, which can give you peace of mind and simplify budgeting your monthly payments.

You’ll need to have sufficient equity in the home. Most lenders will allow you to borrow up to 80-85% of the value of your home, so you need to have more than 15-20% equity. 

Each lender sets its own minimum requirements. Most require a credit score of 620, but some lenders will accept your application with a score of at least 600. The lender will also verify your income to make sure you can afford the payments.

The interest on your home equity loan is tax deductible under limited circumstances. You can only deduct the interest if you used the loan to improve your primary residence. If you used the loan for debt consolidation, you may not deduct the interest. Before taking out a loan, it is always best to check with your tax advisor to see if you would qualify for a tax deduction.

One drawback to home equity loans is that you have to decide upfront how much you want to borrow. 

A HELOC gives you the flexibility to withdraw only what you need during the draw period. That flexibility is useful if you’re using the money for a long-term project and you don’t want to manage the money over time or pay interest on funds you don’t need yet. 

If you're a homeowner needing funds, a Home Equity Line of Credit (HELOC) with a fixed interest rate can be a great option. With a fixed rate, your interest rate will stay the same throughout the loan's life, making it easier to budget your monthly payments. Also, a HELOC can be a flexible and convenient way to access cash for home improvements, debt consolidation, or other expenses without affecting your first mortgage rate or terms.

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