What is a home equity loan? Definition, rates, and how it works

If you're wondering what a home equity loan is, here's the simple answer: A home equity loan gives you a one-time lump sum using the equity you've built in your home as collateral. Because the loan typically has a fixed interest rate and fixed monthly payments, it is a very predictable form of credit. That could make it a good option when you know upfront how much you need to borrow for a major expense like home improvements or debt consolidation.

How home equity loans work

A home equity loan has a fixed interest rate and a fixed repayment term, so your monthly payment stays the same for the life of the loan. If you're still paying off your original mortgage, your home equity loan becomes a second mortgage.

The loan amount you can qualify for depends primarily on your home's value and your equity. Lenders typically base this on your combined loan-to-value ratio (CLTV), which compares your total mortgage debt to your home's market value. 

Most lenders offer home equity loans up to a CLTV of 80%–85%, meaning your first mortgage and new loan combined must stay at or below that percentage of your home's value.

For example, if your home is worth $300,000 and you have a $150,000 mortgage balance, borrowing $100,000 with a home equity loan brings your combined balance to $250,000. That's about 83% of your home's value ($250,000 ÷ $300,000 × 100). If your lender's CLTV limit is 85%, you'd qualify for that amount.

CLTV is only one part of the decision. Lenders also consider your credit history, income, and existing debts when deciding how much you could borrow. 

Home equity loan rates and what affects them

The interest rate on a home equity loan is typically fixed for the life of the loan, so your rate and payment won't change after closing. Rates are generally higher than a first mortgage rate, because a home equity loan's claim on your collateral is lower in priority to your first mortgage.

When the home is sold, your primary mortgage lender gets repaid first. If there’s enough money left, your home equity lender would get repaid second. That means the home equity lender is taking on a higher risk of loss. Even so, second mortgage rates are generally lower than credit card or unsecured personal loan rates, because your home secures the loan.

Your rate depends on several factors, including:

• Your credit score

• CLTV ratio

• Debt-to-income (DTI) ratio, which compares your monthly debt and housing payments to your income

• The loan amount and term

• General credit conditions in the economy

The lowest advertised rates are usually reserved for borrowers with excellent credit, low debt, and plenty of home equity. The average rate for a home equity loan shifts over time with broader market conditions, so shopping around with multiple lenders could help you find the best rate for your situation. 

What a home equity loan is commonly used for

Home equity loans are used for a range of financial goals:

• Debt consolidation: Combine higher-interest credit card or personal loan balances into one fixed monthly payment.

• Home improvements: Fund renovations or repairs that could increase your home's market value.

• Major expenses: Cover costs like medical bills, education, or a business launch.

• Get cash for equity: Access your home equity as cash without replacing your current mortgage.

Home equity loan vs. HELOC

A home equity line of credit (HELOC) is another way to borrow against your equity. It works differently from a home equity loan even though both draw on the equity in your home.

Instead of a one-time loan with fixed payments, a HELOC is a revolving credit line. During the draw period, you can borrow, repay, and borrow again up to your credit limit. Once the draw period ends, you can't borrow anymore, and you have to start repaying the balance you owe.

Here's a quick breakdown of the differences between a home equity loan and a HELOC:

The biggest difference is the rate. Most HELOCs are variable, so the payment could change as rates move, while a home equity loan locks your rate for the full term. If you like the flexibility of a HELOC but want a rate that stays put, Achieve Loans offers a fixed-rate HELOC that combines a predictable fixed rate with the flexibility to borrow, repay, and borrow again up to your credit limit.

How to qualify for a home equity loan

What is needed for a home equity loan? If you want to borrow against your home's value, it’s important to understand the requirements. Here's how you can assess your qualifications for a home equity loan:

1. Check your credit score. Many lenders prefer a minimum credit score of 600–640, with no recent bankruptcies. You don't need perfect credit to qualify.

2. Find your home equity. Check your home's approximate market value with online tools, then subtract what you still owe on your mortgage. That's the amount you can borrow against.

3. Gather income documents. Lenders want proof of steady income, such as pay stubs, W-2 forms, tax returns, or bank statements.

4. Know your DTI ratio. Many lenders cap DTI ratios around 43% for home equity loans. You can use our DTI ratio calculator to learn yours. 

5. Prepare for an appraisal. Lenders often use a digital appraisal to confirm your home's value. An in-person visit is sometimes required. A lower-than-expected value could reduce your loan amount.

6. Apply. Some lenders offer an online application and a soft-check prequalification that won't affect your credit score.

Risks to consider with a home equity loan

A home equity loan could help you reach financial goals and pay for important costs. As with any kind of debt, there are risks involved. Here are a few of the risks of a home equity loan: 

• Your home secures the loan. Your home is used as collateral. If you don't repay the loan, you could lose your home.

• It adds to your monthly debt. If your DTI ratio is already high, you might not have enough room in your budget for another loan payment.

• Closing costs typically apply. You might be able to include them in the loan balance. This could increase your total interest cost over time.

• It reduces your available equity. When you borrow against your equity, you leave less to gain if you sell before the loan is repaid.

Find out if you qualify for a home equity loan or fixed-rate HELOC through Achieve Loans.