With home values appreciating throughout the pandemic, most homeowners have more equity in their homes now compared to two years ago. If you need access to funds for a renovation project, education expense or even debt consolidation, tapping into your home’s equity could provide you with a lower-rate financing option. A home equity loan, which lets you borrow money against the equity you’ve built in your home, provides you with a lump sum of cash at a fixed interest rate.
Home equity loans may be particularly appealing in the current economic climate. Though mortgage rates have surged as the Federal Reserve increases its benchmark interest rate in an attempt to combat rising inflation, home equity loans tend to offer lower interest rates than other types of loans. That’s a significant benefit for anyone looking for financing at a time when rates are only expected to keep going up.
This type of financing may make sense if you own a home and have at least 15% to 20% of equity built up in your home. Unlike a home equity line of credit, or HELOC, you’ll receive the sum of the loan upfront in one lump payment if you’re approved.
A home equity loan is a lower interest rate financing option, but it’s not without risk. When you secure a home equity loan, your home acts as collateral, which means you could lose your home if you’re unable to repay what you borrowed. It’s important to carefully consider whether a home equity loan is right for you before applying for financing.
Here’s everything you should know about home equity loans, how they work, who they’re best for and how they compare to other loan options.
What is a home equity loan?
A home equity loan offers you a lump sum of cash you borrow against the equity built in your house. Tapping into your home’s equity means you are borrowing against the mortgage payments you’ve already made — it won’t replace your existing mortgage payment — it’s a new loan that you’ll repay monthly, along with your existing home loan.
Most lenders require you to have 15% to 20% of equity in your home to secure a home equity loan. To figure out how much equity you have, subtract your remaining mortgage balance from the value of your home. For example, if you have a $500,000 mortgage and you owe $350,000 on it, you have $150,000 in equity. To figure out the percentage, divide this number ($150,000) by your home’s value ($500,000) and you’ll see you have 30% equity available in your home. Lenders will typically let you borrow around 80% to 85% of your home’s equity for a home equity loan. So, in this case, you could borrow up to $120,000 to $127,500.
A standard repayment period for a home equity loan is between five to 30 years for a home equity loan. You make fixed-rate payments that never change, which means even if interest rates go up, your loan rate is locked in.
Current home equity loan rate trends
One of the benefits of home equity loans is that they typically have lower interest rates than personal loans or credit cards, which could be advantageous in today’s rising rate environment. Right now, borrowers with good credit and sufficient equity can secure home equity loans with interest rates around 3%, according to Bankrate, which is owned by the same parent company as CNET.
One potential downside of a home equity loan is that if your property value goes down for any reason, you could end up underwater on your loan. This happens when the balance of your loan becomes higher than the value of your home. That’s what happened to millions of Americans during the 2008 financial crisis. Right now, there’s less risk of your home’s value decreasing below your home equity loan amount, though. Home prices have appreciated as much as 20% in some metro areas across the US over the last two years, and it seems unlikely that they will go down in a significant way anytime soon.
Pros of a home equity loan
- Fixed-rate payments: Your monthly payment will never change even if interest rates rise.
- One lump sum of cash: You receive the entire loan upfront in one disbursement.
- Low interest rates: It has a lower interest rate than other types of personal loans or credit cards.
- Tax deductible interest: If you use it for home renovations, you can deduct the interest from your taxes.
Cons of a home equity loan
- Using your home as collateral: If you fail to make your payments or default on your loan, your lender can foreclose and take ownership of your house.
- Can take longer to receive the funds: It can take more time to receive a home equity loan than a personal loan, for example.
- Closing costs are expensive: Closing costs can range anywhere from 2% to 5% of the loan.
- Your home’s value could decrease after receiving your loan: Although home values are not expected to decrease significantly any time soon, if your home’s value were to drop below your home equity loan amount, you would have what is known as negative equity. Negative equity means you owe more than your home is worth. So, if you were to sell your home, you likely would not receive enough money from a seller to pay off your loan balance.
Home equity loans vs. HELOC
Home equity loans and home equity lines of credit, or HELOCs, are similar, but have a few key distinctions. Both let you draw on your home’s equity and require you to use your home as collateral to secure your loan. The two major differences between a home equity loan and a HELOC are the way you receive the money and how you pay it back.
A home equity loan gives you the money all at once as a lump sum, whereas a HELOC lets you take money out in installments over a long period of time, typically ten years. Home equity loans have fixed-rate payments that will never go up, but most HELOCs have variable interest rates that rise and fall with the economy and overall interest-rate trends.
A home equity loan is better if:
- You want a fixed-rate payment: Your monthly payment will never change even if interest rates rise.
- You want one lump sum of money: You receive the entire loan upfront with a home equity loan.
- You know the exact amount of money you need: If you know the amount you need and don’t expect it to change, a home equity loan likely makes more sense than a HELOC.
A HELOC is better if:
- You need money over a long period of time: You can take the money as you need it and only pay interest on the amounts you withdraw, not the full loan amount, as is the case with a home equity loan.
- You want a low introductory interest rate: Although HELOC rates may increase over time, they also typically offer lower introductory interest rates than home equity loans. So, you could save money on interest charges.
Home equity loans vs. cash-out refinances
A cash-out refinance is when you replace your existing mortgage with a new mortgage, typically to secure a lower interest rate and more favorable terms. Unlike a traditional refinance, though, you take out a new mortgage for the home’s entire value — not just the amount you owe on your mortgage. You then receive the equity you’ve already paid off in your home as a cash payout.
For example, if your home is worth $450,000 and you owe $250,000 on your loan, you would refinance for the entire $450,000, rather than the amount you owe on your mortgage. Your new cash-out refinance home loan would replace your existing mortgage, and then offer you a portion of the equity you built (in this case $200,000) as a cash payout.
Both a cash-out refi and a home equity loan will provide you with a lump sum of cash that you’ll repay in fixed amounts over a specific time period, but they have some important differences. A cash-out refinance replaces your current mortgage payment. When you receive a lump sum of cash from a cash-out refi, it is added back onto the balance of your new mortgage, usually causing your monthly payment to increase. A home equity loan is different — it does not replace your existing mortgage and instead adds an additional monthly payment to your expenses.
A home equity loan is better if:
- You do not want to pay private mortgage insurance: Some cash-out refinances require PMI, which can add hundreds of dollars to your payments, but home equity loans do not.
- You can’t complete a refinance: With rates rising, it’s possible that your mortgage rate is lower than current refinance rates. If that’s the case, it likely won’t make financial sense for you to refinance. Instead, you can use a home equity loan to only take out the money you need, rather than replacing your entire mortgage with a higher interest rate loan.
A cash-out refinance is better if:
- Refinance rates are lower than your current mortgage rate: If you can secure a lower interest rate by refinancing, this could save you money in interest, while providing access to a lump sum of cash.
- You only want one monthly payment: The amount you borrow gets added back to the balance of your mortgage so you only make one payment to your lender every month.
- Less stringent eligibility requirements: If you don’t have great credit or you have a high debt-to-income ratio, you may have an easier time qualifying for a cash-out refi compared to a home equity loan.
- Lower interest rates: Cash-out refinances sometimes offer more favorable interest rates than home equity loans.
FAQs
What is a good home equity loan rate?
Right now, lenders are offering rates that start as low as around 3% for borrowers with good credit, but rates vary depending on your personal financial situation. A lender will base your interest rate on how much equity you have in your home, your credit score, income level and other aspects of your financial life such as your debt-to-income ratio, which is calculated by dividing your monthly debts by your gross monthly income.
How do I qualify for a home equity loan?
You are typically required to have at least 15% to 20% equity built up in your home to qualify for a home equity loan. You must also have enough income and a low-enough debt-to-income ratio to qualify — lenders usually want to see a DTI of 43% or below. Lenders also like to see a minimum credit score of at least 620. Generally speaking, if your credit score is below 700 there is a possibility that a lender will deny you for a home equity loan. The better your credit, the better your chances of being approved for a loan with a low interest rate.
What can I use a home equity loan for?
Home equity loans can be used for anything you choose to spend the money on. Typical life expenses that people usually take out home equity loans to cover are expenditures like home renovations, higher education costs like tuition or to pay off high-interest debt like credit card debt. There’s a bonus for home improvements: If you use a home equity loan for renovations, the interest is tax deductible.
You can also use a home equity loan in an emergency situation or for life events like weddings. But keep in mind that whatever you chose to use a loan for, taking out a large sum of money that accrues interest is an expensive choice you should always carefully consider – especially since you’re using your home as collateral to secure the loan. If you can’t pay it back, the lender could seize your home to repay your debt.
How do I apply for a home equity loan?
Applying for a home equity loan is similar to applying for a mortgage. You need to qualify with a lender or bank who is willing to lend you the money. First, the lender will first want to make sure you have at least 15% to 20% equity in your home. If you do, the lender will take into account your credit score (lenders usually like to see a minimum score of 620), your income and your current debt-to-income ratio to determine whether you qualify and what your interest rate will be. You should be prepared to have financial documents like pay stubs and W2s in order, as well as proof of ownership and proof of the appraised value of your home. It’s important to interview multiple lenders to determine which lender can offer you the lowest rates and fees.
More mortgage tools and resources
You can use CNET’s mortgage calculator to help you determine how much house you can afford. The CNET mortgage calculator factors in variables such as the size of your down payment, home price and interest rate to help you understand how much of a difference even a slight increase in rates can make in the amount of interest you’ll pay over the lifetime of your loan.
