Home equity loans: A complete overview

Of all the differences between owning a home and renting one, the opportunity homeowners have to build equity in their home may be the most significant.

Through a combination of market appreciation and years of mortgage payments, you could end up acquiring a substantial amount of equity in your home. You can cash out this equity when you sell the home or borrow against it to cover other expenses while you own it. One of the most popular ways to tap into your home equity is to get a home equity loan.

Learn more: How to buy a second home

What is a home equity loan?

A home equity loan allows you to borrow money by using the equity in your home as collateral. A home equity loan is considered a type of "second mortgage" because you take it on in addition to your primary mortgage — unlike a mortgage refinance, which involves replacing your original mortgage with a new one. This second loan gives you a lump sum of cash you can use for home improvements or other purposes.

Learn more: What is a mortgage, and how does it work?

How does a home equity loan work?

A home equity loan typically has a fixed interest rate, a fixed term — also known as a repayment period — and a fixed monthly payment that won't change during your term. Repayment periods can range from five years to 30 years.

Interest rates for home equity loans are often lower than rates for other types of debt, such as credit cards. That's because the home equity loan is secured — the technical term is "collateralized" — by your home. If you're unable to make monthly payments, your lender may foreclose on your home.

How much can you borrow with a home equity loan?

The amount you can borrow with a home equity loan depends on your income, your credit history, and how much equity you have in the home, among other factors. Most lenders limit the amount you can borrow to 80% of your home's equity.

There are a few ways to calculate how much you can borrow. One way is to take 80% of your home value, then subtract how much you still owe on your house. The remaining balance is the amount a lender might let you borrow.

For example, if your home was worth $400,000, 80% of that amount would be $320,000. If you still owed $200,000 on your primary mortgage, your home equity loan limit would be $120,000 ($320,000 - $200,000 = $120,000).

If your equity is low or negative, you'll need to wait until the market value of your home increases or you pay off more of your primary mortgage principal before you apply for a home equity loan.

Reasons to get a home equity loan

Homeowners can use home equity loans for a variety of purposes, such as consolidating credit card debt, making home repairs or improvements, buying a car, or financing a child's education. Other uses may include traveling, starting a small business, paying medical bills, investing, or setting up an emergency savings fund. Basically, you can use money from a home equity loan however you see fit.

However, you may want to be cautious if you plan to use your home equity loan to consolidate debt or invest in other assets. Other types of debt, such as credit card bills, may charge higher interest rates than a home equity loan, but you won't lose your home if you can't make your card payment. Also, if you invest and lose money, you could have trouble affording your home equity loan payments. Regardless of how you spend the money, weigh the pros and cons to decide whether it’s worth taking out a home equity loan.

If you use a home equity loan to make improvements to your home, you could recoup part of the cost of your loan when you sell the house.

Interest paid for a home equity loan may be deductible when you file your income tax returns if you use the funds to buy, build, or significantly improve a first or second home that secures the loan.

Alternatives to a home equity loan

Home equity loans aren't free. Like primary mortgages, these second loans involve a variety of upfront fees and expenses in addition to monthly interest charges. These costs might include document preparation fees, recording fees, escrow costs, and attorney's fees, among others. The wide variety of fees is one reason you should shop around and compare loan offers before saying yes to a home equity loan.

Not sure if a home equity loan is right for you? There are several other options for tapping into the equity in your home.

Cash-out refinance

A cash-out refinance is a new mortgage that pays off your existing primary mortgage and gives you an additional lump sum in cash. Your new mortgage will have a higher balance than your original one.

HELOC

A HELOC is a revolving credit line that's secured by the equity you have in your home. Like a credit card, a HELOC allows you to borrow up to your credit limit and then repay — and reborrow — funds when you choose. HELOCs typically have a variable interest rate.

Dig deeper: HELOC vs. home equity loan

Personal loan

A personal loan or line of credit may be either unsecured or secured by assets other than your home or car. Personal loan term lengths and interest rates vary depending on the lender and your financial situation.

HECM

A home equity conversion mortgage (HECM) is a special type of home loan intended for older homeowners who need to access their equity. Repayment isn't required until the homeowner sells the house, moves out, or dies. HECMs are also known as "reverse mortgages."

If a home equity loan sounds like a good fit for your needs, talk with a lender to find out how you can apply. Ask the lender how much equity you'll need, how much you’ll be allowed to borrow, what interest rate you might be offered, and what other requirements you must meet for approval.