What Is a Home Equity Loan? Requirements and Borrowing Limits

Written by Jordan BlansitUpdated: 7th Aug 2022
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A home equity loan, sometimes called a second mortgage, is a fixed-rate loan that lets you tap the equity in your home.

By putting up your house as collateral, you can obtain the cash value invested in your property at a lower interest rate than most consumer debts.

Whether you need cash to renovate your house, pay for an upcoming wedding, or pay down high-interest debt, a home equity loan provides the necessary funds to achieve your goals.

But home equity loans aren’t the right choice for everybody. And if you don’t pay up when the piper comes to visit, not only will you tank your credit score, but you might lose your house, too.

What is a Home Equity Loan?

A home equity loan is a fixed-rate loan that you receive in one lump sum and repay in monthly installments.

Borrowers may secure up to 85% of the equity in their home for personal use, debt consolidation, or even to take a vacation. (Not that we’re recommending that last idea.) Equity is calculated as the market price of your home, minus any mortgages or debts against your house.

But be warned: although borrowing against your home can provide hundreds of thousands in funding, it also means that defaulting can leave you in worse shape than where you started. As such, it’s crucial to take out only what you need or can repay – not what you qualify for.

How Do Home Equity Loans Work?

Home equity loans let homeowners pull cash from one of their biggest assets without breaking the bank.

To secure a loan, you’ll have to contact your mortgage lender or other financial institution – don’t be afraid to shop around for the best rates!

Then, after you’ve applied for a loan and accepted a proposal, you’ll have to cough up fees and closing costs, which may range from 2-5% of the total loan amount. (Though some lenders waive these fees.)

Note that these fees are in addition to the fixed interest rate you’ll pay over the life of the loan, which may start as low as the prime rate plus 2%.

However, your income, employment history, credit history, and debt-to-income ratio may also factor into your total interest rate.

Once you’ve received your lump-sum funding, you’ll typically have to start making payments within a month or so for the life of the loan, which may range from 5-30 years.

And because these are fixed-rate loans, your monthly payment will remain the same for the life of the loan, unlike variable-rate debts.

But keep in mind that home equity loans operate just like a mortgage. If you don’t meet your obligation, the lender has the right to repossess and sell your home to cover their debts.

Home Equity Loan Requirements

Just like other debts, home equity loans come with their own requirements.

Credit Score

Your credit score often factors into whether you can take out a loan, how much you can borrow, and your interest rate.

Typically, the lower your credit score, the higher your interest rate, as creditors view you as more of a lending risk.

When it comes to home equity loans, most lenders want to see a credit score of 620 or higher. However, some lenders offer exceptions to the rule – for a price, of course.

Minimum Home Equity Requirements

The rule of thumb for home equity loans is to own at least 15-20% equity in your property before you use it as collateral.

Debt-to-Income Ratio

Lenders also consider your debt-to-income ratio, or DTI, when evaluating your situation. This is how much you pay in monthly debts, such as your mortgage and credit card bills, compared to your monthly income. To qualify for a home equity loan, your DTI can’t be higher than 43%.

Ability to Repay the Loan

And lastly, lenders want to see that you have the ability to repay your obligation. To do so, your income, employment history, credit history, and DTI must demonstrate your good faith willingness to pay back your home equity loan.

How Do You Get a Home Equity Loan?

Prepare yourself to jump through a few hoops before you run out to apply for a home equity loan.

After all, you’re putting your house up as collateral – it’s in the lender’s best interest and yours, to make sure your T’s and I’s are crossed and dotted.

Step 1: Calculate Your Home Equity

Equity is the difference between your home’s value and what you owe on your mortgage and other house-backed debts.

So, if you own your home outright, your equity is 100%, and you can borrow up to 85% of your home’s total value.

But say you buy a $200,000 house and pay off $100,000 on your mortgage between your down payment and regular monthly installments.

If you wanted to take out a home equity loan on what you own, you could only borrow up to 85% of the $100,000 you own.

If you want to calculate your equity yourself, start with the market value of your home. If you’re unsure of your home’s value, you can use a website like Zillow to approximate the value.

Then, subtract the balance of any loans against your house, including your:

  • Mortgage
  • Home equity lines of credit (HELOC loans)
  • Personal loans

And voila!

Step 2: Home Appraisal

Some lenders require a formal appraisal before offering a loan against your house. You can either take this step preemptively, or you can wait until your lender requests one.

Keep in mind that an appraisal can be a double-edged sword. If the value of your home has risen since you’ve moved in, you may own more equity than you thought without paying a penny more.

But if the value of your house has fallen, you may own less – or even find that you’re underwater on your mortgage.

Step 3: Apply for Your Loan

Once you’ve gotten your appraisal, it’s time to apply for your loan. At this point, you should shop around for different lenders and rates to find the terms that suit your needs best.

Don’t forget to look at credit unions, which may offer more personalized service and better interest rates (though the application process may take a little longer).

After you’ve selected a lender, put in your application. The lender will assess your risk level and overall creditworthiness before making an offer, which will detail:

  • How much you can borrow
  • Your interest rate
  • Terms of repayment

Step 4: Accept Your Offer

Remember that just because you qualify for hundreds of thousands of dollars doesn’t mean you should take out the full amount. Typically, you should only pull out what you need.

If you’re not sure how much that is – for instance, if you’re renovating your home and only know an approximate value – it can be wise to pull out a little extra.

However, again, only pull out the maximum amount you think you need and pay it back if there’s any leftover.

How Do Home Equity Loans Compare to Other Options?

Before taking out a home equity loan, you may want to consider if other options suit your needs just as well.

#1. HELOC vs. Home Equity Loans

A HELOC, or home equity line of credit, works like a credit card backed by your home. A lender preapproves you for a set limit and interest rate with this revolving line of credit, just like a credit card.

Then, during the “draw” period, you can borrow against your credit line as often as you need as long as you repay interest on the sums you withdraw. And once the repayment period begins – around 10 years after the draw period starts – you must pay down both the interest and principal over a period of 10-20 years.

HELOCs are one way to convert your home equity into cash if you have ongoing, irregular, or unknown expenses, such as home renovations, tuition, or even medical debt.

However, while interest rates usually start at the prime rate plus 2%, the rate is variable.

In other words, if the prime rate goes up, your interest rate will rise with it, making it hard to calculate regular payments.

>> More:HELOC vs. Home Equity Loans

#2. Cash-Out Refinance vs. Home Equity Loan

A cash-out refinance allows homeowners to refinance their home for more than they currently owe and receive the excess as a lump sum loan.

This pays off your mortgage entirely and rolls the remaining debt – plus your excess – into a new mortgage with a new term and interest rate.

Unlike home equity loans and HELOCs, a cash-out refinance is less risky for lenders, as it simply replaces your first mortgage rather than adds another mortgage on top.

This means you’re less of a risk to lenders – and you’ll only have to make one mortgage payment to boot!

A cash-out refinance is one way to refinance your home while also paying down large expenses, such as renovations or medical debts.

>> More: How to Refinance Your Mortgage

#3. Personal Loans vs. Home Equity Loans

Personal loans provide a source of financing that doesn’t risk your house in exchange for cash.

But personal loans typically have lower borrowing limits and higher interest rates, even if they’re secured.

Typically, these are better for small, short-term debts or those who worry about losing their homes.

#4. Home Equity Loans vs. Credit Cards

Credit cards are unsecured debts, which leads to higher interest rates. But if you don’t want to – or can’t – use your home as collateral, credit cards can give you access to immediate capital.

And if you time your new credit card applications right, you may qualify for a 0% interest rate on new purchases or balance transfers for up to 18 months.

When Should You Consider Getting a Home Equity Loan?

Generally, home equity loans are best if you know that you need a large, specified sum of money, as you’re guaranteed a final loan amount at closing.

For instance, if you need to consolidate other debts, pay for home renovations or remodels, or cover college tuition, a home equity loan provides a way to cover your obligations.

And if you’re worried about high-interest rates, nabbing a loan while rates are low means you’ll avoid the volatility that may come with HELOCs.

Advantages of Home Equity Loans

  • Lower interest rates than unsecured loans
  • Easy to plan payments due to fixed interest rates
  • Interest may be deductible on some home improvement projects
  • Longer terms than most consumer loans
  • No restrictions on spending funds
  • Access to a large lump sum

Disadvantages of Home Equity Loans

  • If you fail to repay, your lender may foreclose on your property
  • Reduces home equity and may keep you in debt longer
  • Closing costs run up to 5% of the loan amount, or $5,000 per $100,000 borrowed
  • If your home’s value drops, you’ll take a loss when you resell
  • Interest accrues on the entire loan amount
  • You risk-taking on a second mortgage if you don’t own your home outright

Are Home Equity Loans Hard to Qualify for?

While the equity is technically yours to borrow against, qualifying for a home equity loan is another story. Requirements vary by lender, but you can usually expect to need:

  • Proof of consistent employment or income
  • A FICO credit score of 620 or higher
  • A clean credit report
  • 15-20% equity in your home
  • A maximum DTI of 43%

Home Equity Loan Tax Deduction

Another unique benefit of home equity loans was written into law in the Tax Cuts and Jobs Act of 2017.

This law suspended the deduction for interest paid on all home equity loans and HELOCs until 2026.

However, if you use the funds to “buy, build, or substantially improve the taxpayer’s home that secures the loan,” you may still be able to write off the interest.

Bottom Line: Home Equity Loans Explained

Taking out a home equity loan lets you borrow against the equity you already own in your property.

Your lump sum payment means you’ll have the cash on hand to cover necessary – or even frivolous – expenditures when you need it.

And because you secure your debt against your home, you won’t break the bank to pay for your purchases, either.

However, failure to repay your loan could tank your credit score or even put you in foreclosure.

As such, if you’re worried about your ability to repay, you might opt for a less risky alternative than using your house as collateral for your debts.

Jordan Blansit
Jordan Blansit

Jordan Blansit is a Senior Writer, Researcher, & Product Analyst for SimpleMoneyLyfe with an inexplicable predilection for mortgages, investing, and personal finance. When she’s not click-clacketing from the comfort of her living room, you can find her in the California Redwoods or Oregon Siskiyous. Jordan’s areas of expertise are mortgages, personal loans, credit cards, and investing.