Home equity loans: How do they work and do you need one?

A home equity loan lets you borrow against the equity you’ve built in your home. You receive the funds as a lump sum and repay the loan in monthly installments. Because these loans are secured by your home’s equity, they’re often referred to as second mortgages. 

Many people take out home equity loans for purposes such as covering a major purchase, consolidating debt, or home improvement projects. Home equity credit lines totaled about 241,000 in the fourth quarter of 2023, according to a report by ATTOM Data. But home equity loans come with downsides, so it’s a good idea to understand the risks and alternatives before applying for one.

How a home equity loan works

When you take out a home equity loan, you’re borrowing money against the equity you’ve built in your home. Equity is the difference between what your home is currently worth and how much you owe on your mortgage.

You’ll receive the money as a lump sum payment and start paying it off immediately. Home equity loans usually have fixed interest rates, meaning the amount you owe each month won’t change over time.

Home equity loans are often referred to as a second mortgage because they’re secured with your house as collateral. This means you’ll be responsible for another monthly payment on top of your original mortgage payment.

Here are a few pros and cons of home equity loans to consider:

How to get a home equity loan

When you apply for a home equity loan, you’ll go through a process that’s similar to taking out a mortgage. Typically, you’ll follow these five steps:

1. Get an appraisal

To figure out how much equity you could borrow from, you’ll need to schedule a home appraisal. An appraiser will assess your home and compare it to similar houses in your area to determine how much your home is worth. Appraisals generally cost $300 to $500 and are usually included in your closing costs.

2. Determine how much equity you have

Once your home is appraised, you’ll subtract your existing mortgage balance from the appraised value of your home to estimate how much home equity you have. Keep in mind that most lenders will only allow you to borrow up to 80% of your available equity.

3. Compare lenders

Next, you can comparison shop among different lenders. It’s a good idea to get quotes from at least three different lenders so you can find lower interest rates and the best terms for your loan. Consider what fees they charge, such as annual fees, origination fees, or application fees.  Also consider what terms they may give you — some lenders may charge more for some fees and less for others, so try to make an overall comparison. You also don’t have to apply with the same lender you used to get your mortgage, but you can if it’s the best offer. 

4. Submit a loan application

Once you’ve chosen a lender, you’ll complete a loan application. Be prepared with significant documents, such as a government-issued photo ID, recent pay stubs and W-2s, and recent mortgage and property tax statements.

5. Close on the loan

At closing, you’ll sign any necessary documents and receive the full home equity loan amount. You’ll also start making monthly loan payments immediately.

How to qualify for a home equity loan

The exact requirements to get a home equity loan will vary depending on your lender, but here are some common guidelines:

• At least 15% to 20% equity in your home: Since lenders will typically only approve you to borrow up to 80% of your home’s equity, you’ll need to have sufficient equity to borrow from. Most lenders will want you to have about 15% to 20% equity in the home. 
• A credit score of 620 or higher: This also varies by lender and your situation. You can typically qualify with a credit score around 620, but some lenders might have higher requirements based on their risk tolerance. 
• A debt-to-income ratio (DTI) below 43%: DTI compares your monthly debt payments to your gross monthly income. Lenders use this to gauge how likely you are to pay back a home equity loan.
• Income history: Be prepared to show your lender that you have a steady income and work history. A lender might request your W-2s from the previous two years and recent pay statements to show your income. 

Home equity loan vs. HELOC vs. cash-out refinance

If you’re not sure whether a home equity loan is the right choice for you, a home equity line of credit (HELOC) and cash-out refinance are popular alternatives:

• A HELOC is an open-ended line of credit that allows you to borrow against your home equity. You can borrow up to your limit for a set number of years, called a draw period. When you enter the repayment period, you start making payments on the debt. 
• A cash-out refinance allows you to refinance your home for more than you owe and receive the difference in cash. It replaces your existing mortgage, so you’ll have new loan terms.

The following table highlights some of the main differences and eligibility criteria for each type of loan:

More alternatives to home equity loans

There are other ways to get extra funds if you decide not to borrow against your home. Here are some alternatives to home equity loans:

• Credit cards: A credit card allows you to borrow funds up to a pre-approved spending limit. It’s an unsecured line of credit, so you won’t put your home at risk. However, credit cards typically come with higher interest rates than home loans or personal loans, so you should only consider this option if you can receive a card with an introductory 0% annual percentage rate (APR). Just keep in mind that if you can’t pay off your balance before the introductory period ends, the card’s regular APR will kick in and apply to any remaining balance.
• Personal loans: A personal loan is similar to a home equity loan in that you receive a fixed amount of money upfront. Since these loans are unsecured, you won’t put your home at risk if you default on the loan. The application process is also easier and faster than taking out a home equity loan. However, you may not be able to borrow as much with a personal loan, and you’ll likely receive shorter repayment terms.
• 401(k) loan: Some people may choose to tap into their 401(k) retirement account to get needed funds. If you try to withdraw funds from a 401(k) before you retire, you’ll have to pay taxes and penalties for using the money early — including a 10% federal income tax if you’re less than 59 ½ years old. With a 401(k) loan, however, you can take out a lump sum of money and pay it back into the account with interest, typically over five years. You can typically borrow up to 50% of your 401(k), up to $50,000. Keep in mind that any money that you take out won’t be helping grow your retirement funds. In addition, if you default on the loan, you’ll owe taxes on the amount you borrowed as if you’d withdrawn it early.
• Reverse mortgage: With a reverse mortgage, borrowers older than 62 can access funds using their home as collateral. The balance of the loan goes up over time as interest and fees accrue. If you live in the house and keep the home maintained and current on property taxes, you won’t have to make payments on the loan. A reverse mortgage is typically paid back when you sell the home or move out. It can be useful for homeowners who want some extra cash without adding a monthly loan payment. However, the closing costs for a reverse mortgage can be higher than other home loan options, and it steadily lowers the equity in your home over time. 

Home equity loan FAQ

What is the purpose of a home equity loan?

A home equity loan allows you to borrow against the equity you’ve accumulated in your home. Most people take out a home equity loan to finance a major purchase or for  high-interest credit card debt consolidation. 

Is it good to borrow from home equity?

Taking out a home equity loan comes with benefits and drawbacks. These loans come with fixed interest rates, so you’ll know how much your payments will be each month. Additionally, the borrowing costs are lower than what you’d receive with other types of loans.

However, you’re using your home to secure the loan. If you default on a home equity loan, you risk losing your property. You’ll have to make home equity loan payments on top of your existing mortgage payment, so you should make sure you can afford both payments each month.

What is home equity?

Equity is the difference between the current value of your home and how much you owe on your mortgage. Your equity increases over time as you pay the principal on your mortgage and the amount you owe goes down. Your equity can also increase if the value of your home goes up, which is why you’ll need to get an appraisal before you apply for a home equity loan. 

Can I take equity out of my house without refinancing?

Yes, home equity loans and HELOCs allow you to access the equity in your home without refinancing. You won’t have to pay closing costs, but your lender may charge other fees, such as for an appraisal. Make sure you understand all of the terms and conditions that come with your loan.