What is a home equity loan?

As a homeowner, you don’t just own a physical building. You also own hidden wealth called home equity. Home equity represents the portion of your home's value that you own outright that often gets bigger over time as you pay down your mortgage and the value of your home typically goes up. 

A home equity loan could help you tap into that hidden wealth, often at lower interest rates than other types of personal loans or credit cards. Home equity loans are installment loans, typically with fixed interest rates, secured by your home.

Your home equity loan can be used to help you reach a variety of financial goals:

• Consolidate higher-interest debts

• Pay for home improvement projects

• Fund major expenses like starting a business

Your maximum loan amount and interest rate will generally depend on your credit score, the value of your home, your existing mortgage amount, and other factors. Let's dive in.

How do home equity loans work?

A home equity loan works by allowing you to borrow against your home equity in a lump sum. The loan has a fixed interest rate and fixed repayment term, which means your monthly payment stays the same for the life of your loan. If you’re still paying off your purchase mortgage, your home equity loan is a second mortgage.

How much can you borrow with a home equity loan?

Your home equity loan amount depends primarily on your home's value and your equity. To figure this out, lenders typically use your combined loan-to-value ratio (CLTV), which compares your total mortgage debts vs. your home's market value.

Most lenders will offer home equity loans based on a CLTV of 80% to 85%. That means the combined amount of your first mortgage and your new home equity loan must add up to 85% or less of the value of your home. 

Example: Let’s say your home is worth $300,000 and you have a $150,000 mortgage balance. You’d like to borrow $100,000 with a home equity loan. 

Step 1: Add your mortgage and your home equity loan 

$150,000 + $100,000 = $250,000 

Step 2: Divide the result by the worth of your home 

$250,000 / $300,000 = 0.83 

Step 3: Multiply the result by 100 to get a percentage

0.83 x 100 = 83% 

If your lender has a CLTV ratio of 85%, you’d be safely under that amount with your $100,000 home equity loan combined with your mortgage.

While your CLTV is key, it isn't the only factor lenders will consider. Each lender will have its own loan maximums. Additionally, your credit history, income, and other debts may also play a role in your maximum loan size and interest rate.

Real-world home equity loan example 

Let’s say you own a house that is worth $500,000 and you owe $300,000 on the mortgage. You have fair or better credit (a credit score of 670 or higher). 

You want to borrow $100,000 for a new kitchen renovation. Your CLTV ratio is 80%. Here’s the math: 

1: $300,000 + $100,000 = $400,000

2: $400,000 / $500,000 = 0.80

3: 0.80 x 100 = 80%

• Will you qualify for a home equity loan? Since we’re assuming that you have a fair-or-better credit score (670 or higher), and your desired loan amount puts you within the 80% CLTV limit that most lenders prefer, you would be likely to qualify. 

• What is your home equity loan interest rate? The exact interest rate will depend on overall market conditions, and some lenders offer lower rates. Shop around for interest rates to get the best deal.

• Do home equity loans have higher interest rates than mortgages? In general, your interest rate on a home equity loan is likely to be higher than the rate on your first mortgage. That’s because second mortgages like home equity loans are seen as riskier for lenders, so they have to charge higher rates. 

• Are home equity loans cheaper debt than credit cards? Home equity loans are secured debts, with your home as collateral. That means your home equity loan APR is likely going to be lower than credit cards or other personal loans. 

Is a home equity loan the same as a HELOC?

No, a home equity line of credit (HELOC) is a little different from a home equity loan. You might think of it as a reusable home equity loan—to a point.

Instead of a lump sum then fixed payments, a HELOC is a revolving credit line. The HELOC has a draw period when you can borrow, repay, then borrow again up to your limit over and over. Once the draw period ends, you can't borrow anymore and you enter the repayment period.

Here’s a quick breakdown of the differences between a HELOC vs. home equity loan:

The main drawback of a HELOC vs. a home equity loan is that most HELOCs are variable rate, so if interest rates go up, so will your payments. Some lenders, like Achieve Loans, offer a fixed-rate HELOC. A fixed-rate HELOC could give you the benefit of a predictable, fixed rate (like a typical home equity loan) along with the borrowing flexibility of a HELOC. 

What are the risks of a home equity loan?

Getting a home equity loan could help you reach financial goals and pay for important costs. Keep in mind there are some risks, just like with other kinds of debt. 

Here are a few risks of a home equity loan: 

• Your home secures the loan. Just like a first mortgage, a home equity loan uses your home as collateral. Missed payments could result in foreclosure. 

• Adds new debt. If your debt-to-income (DTI) ratio is already high, you might not have enough room in your budget for another loan payment. 

• Closing costs typically apply. Some home equity loan lenders will let you roll the closing costs into your loan. Doing this could increase your total interest costs over time. 

• Reduces available equity. If you borrow from your home equity, this reduces the amount of gains you could earn from your house if you sell before the loan is fully repaid. 

Getting a home equity loan can be a smart move depending on your goals and financial situation. Make sure you understand the pros and cons, costs, fees, and possible risks to your personal finances. 

How do you qualify for a home equity loan?

Borrowing against your home’s value starts by understanding the home equity loan requirements. Here are steps to qualify for a home equity loan: 

1. Check your credit score. You don’t need perfect credit for a home equity loan. Most lenders prefer to lend to borrowers with at least a minimum credit score of 600 to 640 and no recent bankruptcies.

2. Understand your home value and home equity. Look up the approximate market value of your home with online tools and subtract the amount you still owe on your mortgage. That number is your home equity. This is the amount you borrow against.

3. Gather documents to verify your income. Lenders generally want proof that you have steady income to repay your home equity loan. You might need to share recent pay stubs, W-2 forms, tax returns, and recent bank statements for income verification.  

4. Know your debt-to-income (DTI) ratio. Another factor in getting approved for a home equity loan is your debt-to-income (DTI) ratio. This shows how much of your monthly pre-tax income is already paying for housing and other debts, like your mortgage, car loan, and credit cards. A DTI ratio of 43% is usually the limit for most home equity loans. 

5. Be ready for a property appraisal. The lender may want an in-person appraisal, but will more likely choose a digital appraisal. If the lender can’t confirm that your home is worth enough, you might not qualify for a home equity loan—or you might be offered a lower loan amount. 

6. Apply for a home equity loan. Many lenders have an easy online application process, while others will let you apply by phone. Many let you prequalify with a soft credit check that won’t affect your credit score.

Want to learn more about home equity loans and fixed-rate HELOCs from Achieve Loans? Find out if you qualify with no impact to your credit.