Sometimes, you need a large amount of money.
Maybe it’s to pay for something like a wedding or school, or maybe it’s to pay off debt on your credit cards.
If you own your home, one option could be a home equity loan. This is a loan that uses the ownership you have in your home and converts it into cash you can use for whatever you need.
However, tapping into your home equity comes with costs and risks — including losing your home. So you’ll want to carefully consider whether it’s the right borrowing option for your circumstances.
Erika Taught Me
- Home equity loans are a second mortgage on your home.
- A home equity loan is backed by the ownership you have in your home.
- When you get a home equity loan, you could lose your home if you don’t make payments.
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How Does a Home Equity Loan Work?
When you take out a mortgage, you actually don’t own the whole home — your down payment is the only portion that you own outright.
Because most of the money for the purchase came from the lender, they have more of a “right” to your home.
But the good news is that every time you make a payment on your mortgage, you build more ownership, or more “equity.” And as you build more equity, you can eventually borrow money from it with a home equity loan.
READ MORE: What Do You Need to Know About Mortgages?
How to calculate home equity
Let’s say you put $10,000 down on a home that costs $250,000. You got a 30-year fixed-rate mortgage of $240,000 at 7%.
After 10 years, your loan balance is down to $205,554. Plus, your home has appreciated and is now worth $285,000.
To calculate your home equity, you subtract what you still owe from the current market value of your home.
In this example, your home equity is $285,000 – $205,554 = $79,446.
When you get a home equity loan, the lender looks at how much equity you have and then makes a new loan based on that. It’s a second mortgage on your home, using your equity to secure it.
Your original mortgage doesn’t go away — you just now have two loans on your home.
Home equity loan requirements
Just because you have nearly $80,000 in home equity doesn’t mean the bank will lend you the full amount. Some banks will lend you only enough to bring your total loan-to-value (LTV) ratio up to 80%.
Your LTV ratio shows how your debt on your home compares to its market value. In our example, 80% of a home worth $285,000 is $228,000.
So, since you still owe $205,554 on your home, your access to home equity will be limited. In this case, you can only borrow enough to bring the total debt up to $228,000.
That means the bank will likely only approve you for up to $22,446.
Some banks will let you have an LTV of up to 90% or 95%. You can shop around to see what’s available.
You will probably have to meet a minimum credit score (often at least 620, although some lenders allow lower) and show proof that you have regular income so the lender knows you’re likely to make payments.
The bank might also require an appraisal of your home’s value.
READ MORE: How To Increase Your Credit Score the Right Way
Difference between a HELOC and a home equity loan
A home equity line of credit (HELOC) also uses the equity in your home, but instead of getting a lump sum, you get access to a credit line that you can tap into as needed (like a credit card).
However, unlike a credit card, with a HELOC, there is a “draw period” of typically up to 10 years. This is when you can withdraw the money, and after that, you’re required to start repaying. With a credit card, you can keep withdrawing and repaying indefinitely.
HELOCs also have eligibility requirements, like a set LTV and minimum credit score.
When Is a Home Equity Loan a Good Idea?
Getting a home equity loan means taking out more debt. So you want to be extra sure that you’re taking it out for a good reason — especially since you can lose your home if you don’t make your payments!
That said, there are some situations where it might make sense and be a better option than credit cards or other types of loans.
Home equity loan for debt consolidation
One reason people choose a home equity loan is to consolidate their debt. A home equity loan often has a lower interest rate than credit cards and unsecured personal loans, so you can pay off the debt faster.
Also, it can be hard to get a personal loan if you have a large amount of debt. Having your home as collateral might make it easier.
Home equity loan for home improvements
Another time to get a home equity loan might be to fix up your home. If you’re doing a major kitchen remodel or building more rooms, that can cost you a lot of money.
A home equity loan can help you make those changes and potentially improve your ability to sell the home later.
Plus, you might even get a tax deduction for the interest you pay (check with a tax professional to be sure).
READ MORE: How Do Taxes Work?
Home equity loan for large purchases
Finally, some people get a home equity loan to help pay for things like a wedding or vacation, or even to help with college.
Depending on the terms of the loan, the interest rate might be lower than other loans or putting the purchase on your credit card.
Pros and Cons of Home Equity Loans
Whether you should take out a home equity loan depends on your circumstances.
If you need a large chunk of cash and you’re confident that you’ll be able to handle payments, a home equity loan might be a good choice.
But there are risks — you don’t want to default and lose your home.
Pros
- Interest rate: You can usually get a large home equity loan at a lower interest rate than for a personal loan.
- Credit score: By using your home as collateral, you reduce the risk for the lender — they can just take your home if you don’t pay. Because of that, you might still qualify with a lower credit score.
- Tax deductions: Depending on how you use the loan, a portion of the interest you pay might be tax-deductible.
Cons
- Costs: Since a home equity loan is a new loan, you may have to repay closing costs and origination fees. Even some “no-cost” home equity loans wrap the closing costs into the loan amount — which increases the balance you pay interest on. Read the fine print of your loan before signing!
- Foreclosure: Because you secure the loan with your home, you risk losing your home if you can’t make payments. Consider whether you want to risk your home before using a home equity loan for a large, unnecessary purchase.
- Turning unsecured debt into secured debt: Your home probably isn't at risk if you default on your credit cards. But if you use a home equity loan for debt consolidation, you’ve now turned that unsecured debt into a riskier debt with your home as collateral.
Carefully weigh the risks of a home equity loan since the consequences can be dire if you aren’t careful.
Home Equity Loan Alternatives
A home equity loan isn’t your only choice for debt consolidation, home improvements, or large purchases.
Before deciding that a home equity loan is a good idea, here are some alternatives to consider.
Savings
Can you save up for the purchase instead of borrowing?
If the expense isn’t urgent and you have time to save, a high-yield savings account can be a good place to keep your savings while earning decent interest.
If you’re facing an unexpected expense but have an emergency fund, that might be better than going into debt.
Unsecured loans
If you qualify for an unsecured loan and can get a relatively low interest rate, that might be better than using your home. Run the numbers and consider your financial goals.
Student loans might work better for education, and some personal loans have competitive interest rates.
Help from family and friends
Tap into your network. See if some of your family and friends can help you financially or give you a low-rate loan.
Part-time job or side hustle
Instead of getting a home equity loan, consider looking for ways to earn more money — if you have the time and ability.
FAQs
What can I use a home equity loan for?
There are very few restrictions on what you can use a home equity loan for. Some common uses include debt consolidation, home improvements, and large purchases.
How long does a home equity loan take?
It often takes between two and six weeks to get a home equity loan, depending on the lender and other factors.
Can you get a home equity loan with bad credit?
Yes, it’s possible in some cases to get a home equity loan with bad credit. Since you secure the loan with your home, it can increase your chances that a lender will take the risk.
Is home equity loan interest tax-deductible?
The interest on a home equity loan can be tax-deductible in specific circumstances. You must use the funds from the loan to make home improvements and meet other requirements. Check with a tax pro before claiming a tax deduction on your home equity loan’s interest.
TL;DR
If you own your home, you may be able to use your equity to get a loan for home improvements, debt consolidation, or a large expense like a wedding. The catch is that your home becomes collateral — meaning if you don’t make your payments, the bank could take your home.
If you’re looking for ways to manage your debt or pay off large bills, check out these episodes of the Erika Taught Me podcast:
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