How does a home equity loan work?

Buying a home is more than an investment in future wealth; you could use it to reach financial goals right now, no sale required. As you pay down your mortgage and/or your home's value increases, your home equity also grows. That equity could be the ticket to big borrowing power.

A home equity loan lets you borrow a lump sum of money using your home equity as collateral, which is security that backs up the loan. How much you can borrow is based on how much equity you have and your overall qualifications. You repay a home equity loan in fixed monthly payments over a set term.

Since your home is the collateral, a home equity loan can be a big decision. Let's go over how home equity loans work so you can make a confident choice with all the details.

How does a home equity loan work?

Most home equity loans follow a similar structure:

1. You apply for the loan.

2. The lender evaluates your home equity, credit, income, and existing debts to make a decision.

3. If approved, you get the money as a single lump sum. 

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

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

While the basic process is simple enough, some of the specifics may require more information. Let's go over some of the important parts in more detail:

• How equity is calculated. Lenders typically conduct an appraisal or digital valuation to find your home’s current value. Your mortgage balance is subtracted from the home’s value to figure out your home equity.

• How much you may be able to borrow. This is largely based 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 original mortgage and the home equity loan combined have to stay within this limit.

• How you receive the money. You receive a single lump-sum payment from the lender. The usual payment method is a direct deposit to your bank account, but some lenders 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

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, let’s look at how to figure out 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 to get to 80% of your home’s value in secured loans:

$240,000 - $180,000 = $60,000 

In this scenario, you could potentially get a home equity loan for up to $60,000, because that’s the lender’s limit minus your mortgage balance. Other factors may 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 can use a home equity loan for almost anything. Lenders normally send the money to your bank account, and then you decide what to do with it. Some of the most common examples include using a home equity loan:

• To pay off debts

• For a home remodel

• For a major purchase

You may get the most benefit from a home equity loan when you use it to substantially improve or remodel your home. That's because the loan interest may be deductible in these cases. Consult a tax professional to learn more about potential tax impacts.

Home equity loan vs. HELOC

A home equity line of credit (HELOC) is another way to borrow against your home equity. The main difference is that a HELOC is a revolving line of credit, not a one-time loan. Here’s a HELOC vs. home equity loan comparison to help you figure out which one is better for you.

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 provides 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

Repaying a home equity loan is similar to repaying your mortgage. You pay the same amount every month by the due date for the life of your 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 find out how much you could borrow and learn about 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 for a home equity loan, you can find out what options your lender offers and choose the term you want.

Longer terms can have lower monthly payments, but cost more in interest overall. Choose a term that balances affordability with overall cost.

Home equity loan pros and cons

Here are the biggest pros and cons of home equity loans.

Pros

• Turn home equity into cash

• Predictable fixed payments and terms

• Competitive interest rates

• Wide range of repayment terms available

Cons

• Closing costs

• Reduced home equity

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

• Less flexible than HELOCs

What are the negatives of a home equity loan?

Home equity loans have closing costs that normally range from 2% to 5% of the loan amount. A home equity loan also reduces the equity you have in your home, and there’s the risk of foreclosure if you default. Compared to HELOCs, home equity loans are less flexible, because you can’t borrow more as you repay your balance.

Is a home equity loan a good idea?

Home equity loans could work out well if you want to borrow at a reasonable rate, have a decent amount of equity in your home, and can afford the monthly payments. Whether a home equity loan is a good idea depends on several factors, including your:

• Credit score

• Income and existing debts

• Reasons for borrowing

A fair to good credit score could 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.

Is it smart to borrow from home equity?

Borrowing from home equity could be a smart way to consolidate debt or pay for a big expense, like a remodel or home repair. What’s most important is that you don’t overextend yourself. Only get a home equity loan if you’re confident you can make the payments.

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. Achieve loans have a draw period and a fixed interest rate. Here are a few other features to 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

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.