How does a home equity loan work?

As you pay down your mortgage and your home's value increases, your equity also rises. Equity is the difference between what you owe on your home and what it's worth.

A home equity loan could help you access your home's value in cash. Here’s how it works. 

What is a home equity loan?

A home equity loan is a loan that allows you to borrow against your home equity, using your home as collateral. Collateral is something you pledge as a guarantee that you’ll repay the loan. For any mortgage, if you don’t repay the loan, you could lose your home. The lender could sell it to recover the money you owe. Collateral helps protect the lender from losses. Secured loans typically result in better loan terms for the borrower (because of that extra layer of protection the collateral provides). 

Home equity loans give you access to a lump sum of cash that you repay over time, with interest. You could use a home equity loan for virtually anything, from consolidating other debts to home improvements to emergency expenses.

Home equity loans are a type of second mortgage that you can have in addition to the mortgage you took out to buy the home. A home equity loan is different from a home equity line of credit (HELOC). 

While a home equity loan lets you borrow a lump sum, a HELOC is a revolving line of credit that works sort of like a credit card. HELOCs are also secured loans, using your home as collateral.

Read: HELOC vs. home equity loan: similarities, differences, and how to choose

How does a home equity loan work?

A home equity loan works by allowing you to convert some of your home equity to cash. When you apply for a home equity loan, the lender reviews the specifics of your financial situation to decide if you qualify. If you're approved, you get a lump sum of money that you can use any way you want. 

Here's what you should know about how home equity loans are structured. 

• You may be able to choose your loan repayment term, which determines your monthly payments. Your lender may also allow you to choose your payment due date.

• Your monthly payment is composed of principal and interest, which the lender should break down for you in an amortization schedule.

• You should make your monthly loan payments as scheduled, separate from your regular mortgage payments.

• A prepayment penalty may apply if you pay your loan off before the term ends. Not all lenders charge a prepayment penalty.

Home equity loans usually have fixed interest rates, which means the rate—and your payment—won't change over the life of the loan. The payment you make on day one will be the same as the last payment you make. The only thing that changes is how much of each payment goes to principal vs. interest over time. 

How long can you take to repay a home equity loan? Lenders decide what terms to offer, but generally, you may have up to 30 years to repay a home equity loan. That's similar to the terms you can get with a mortgage when you buy a home. 

As you compare home equity loan terms, remember that:

• A shorter loan term means you'll pay less interest, but your monthly payments will be higher. 

• A longer loan term can leave you with lower payments, but you'll pay more interest overall. 

The timing to get a home equity loan is typically a little faster than the timing for a mortgage to purchase a home. From application to approval to funding is often within two weeks. Once you’re approved, it’s possible to get the funds in as little as seven days.

What can you use a home equity loan for?

A home equity loan offers a lot of flexibility, as the money can be used for almost anything. Some of the most common uses for home equity loans include:

• Home equity loan to consolidate debts

• Home improvements, repairs, and renovations

• College expenses

• Large planned expenses, like a wedding 

• Vehicle purchases

• Business expenses

• Emergency expenses

Home equity loans have a lot of appeal because there are so many ways you can put the money to work. A home equity loan could help you work toward your financial goals, or simply get through a tough time if you're coping with a financial hardship. 

How do you qualify for a home equity loan?

Lenders set the requirements for home equity loan approval, and every one is different. In terms of what it takes to get a home equity loan, the list usually includes these factors.

Equity

You'll need to have enough home equity to get a home equity loan. Lenders limit how much they’ll borrow, compared to your home’s value. 

If a lender says they require 15% equity, that means you need to have that amount of equity after adding the new loan to your current mortgage balance. This is called the combined loan-to-value ratio. If you currently have 15% equity and that’s the lender’s requirement, you don’t have room to borrow more. 

You can quickly calculate your equity by subtracting your current mortgage balance from your estimated home value. 

Credit scores

Lenders use your credit scores to gauge how likely you are to repay what you borrow. It’s usually easier to get approved for a loan if you have good credit, which could mean a credit score of 670 or higher. It’s possible to get a home equity loan with a lower credit score. Some lenders, including Achieve Loans, may have more flexible requirements for borrowers who are borrowing for debt consolidation. 

Income

You'll need to show a lender you have steady income to repay a home equity loan. The more you want to borrow, the more income you might need to qualify.

Debt-to-income (DTI) ratio

Your DTI ratio measures how much of your income goes to debt payments and housing each month. The lower this number is, the better as it shows lenders that you may have enough room in your budget for a new payment.  

Getting rate quotes can give you an idea of how likely you are to qualify, and what interest rate you might pay for a home equity loan. Look for lenders that offer quotes with a soft credit check, which protects your credit score while you shop around.  

How much can you borrow with a home equity loan?

The amount you can borrow with a home equity loan is determined by several factors. Your home's value is a key consideration, but lenders look at more than just the dollar amount of equity you have. 

This is where loan-to-value (LTV) and combined loan-to-value (CLTV) ratios come into play. 

• Loan-to-value measures the amount of your original mortgage on the home relative to its value. 

• Combined LTV measures the amount of all mortgages on the home, including home equity loans, relative to its value. 

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

For example, say you owe $200,000 on a home that's worth $500,000. If the lender allows for an 80% combined loan-to-value ratio, you can borrow up to $200,000 on your home equity loan.

Besides the LTV limit, lenders may have a maximum dollar amount they will loan. For example, Lender A might cap home equity loans at $100,000 while Lender B allows you to borrow up to $500,000. 

How do you repay a home equity loan?

Repaying a home equity loan isn't that different from repaying the mortgage you took out to buy the home. On your scheduled due date, you pay the required amount. 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. Let's say you get a $50,000 home equity loan with a 10% interest rate. 

Use a home equity loan payment calculator to find out what you'll pay monthly and in interest with different loan amounts, repayment terms, and rates. 

Is a home equity loan a good idea?

Home equity loans are good for people who want to borrow at reasonable rates, have a decent amount of equity in their homes, and can afford the required monthly payments. Whether a home equity loan is a good idea for depends on several factors, including your:

• Credit scores

• Income and ability to repay a second mortgage, on top of your first loan

• Reasons for borrowing

Good credit should make it easier to qualify for a home equity loan and get a lower interest rate. Steady, consistent income could help you keep up with your payments over time and reduce the odds of losing your home because of default. 

A home equity loan could be worth it if you're using it to make improvements that increase your home's value, or to consolidate high-interest debt so you can pay it off faster. Splurge purchases, on the other hand, probably aren't the best use for your equity. 

Home equity loan from Achieve Loans

Achieve Loans 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 customize your term and payment schedule

• Fast funding

• Loans up to $300,000

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

• No refinance is required if you want to keep your current mortgage terms

It’s a big decision. That’s why Achieve Loans have 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. 

Learn more about the Home Equity Loan offered through Achieve Loans.