Last updated: June 20, 2024

Mortgage Products

What is a home equity loan? How does it work?

Young couple in their kitchen reading about how home equity loans work.

Your home is one of your greatest assets. As you pay down your mortgage and property values in your neighborhood rise, the cash value of your home may increase. If you meet the qualifying requirements set by a mortgage lender, you may be able to access this cash with a home equity loan.

What is a home equity loan?

A home equity loan (also commonly known as a second mortgage or second lien) is a loan taken out against the equity in your home. Equity is the difference between the current market value of your home and the amount you still owe on your mortgage. This type of loan allows you to borrow a lump sum of money using your home as collateral. 

A few key points to keep in mind:

  • Collateral: Your home serves as collateral for the loan, meaning that if you fail to repay it, the lender could potentially foreclose on your home.
  • Fixed interest rate: Home equity loans typically come with fixed interest rates, which means your monthly payments remain consistent throughout the loan term. A home equity line of credit (HELOC) is another way to borrow money from your home equity but works more like a revolving line of credit and most often comes with variable rates.
  • Uses: Home equity loans can be used for a variety of purposes like home improvements, debt consolidation, education expenses, or even a dream vacation.

Before diving into a home equity loan, you may want to understand the risks involved, assess your financial situation, and consider your borrowing needs.

How much home equity do you have?

Simply put, your home equity can be calculated by subtracting all debts secured by your home from your home’s current fair market value.

  • For example, if your home is worth $400,000 and your current mortgage is $240,000, then you have $160,000 of equity in your home.

Your borrowing ability depends on your combined loan-to-value (CLTV) ratio. CLTV is your new loan amount plus your mortgage balance, divided by your home value.

  • In the example above, you could potentially borrow up to $120,000 of your home equity with a lender that approves borrowing up to a 90% CLTV limit. This is because a new loan amount of $120,000 plus a $240,000 existing mortgage balance divided by the $400,000 home value is equal to a 90% CLTV ratio.

CLTV borrowing limits may vary by lender, and your borrowing ability will also depend on other factors for eligibility such as your credit score and debt-to-income (DTI) ratio.

READ MORE: What is a loan-to-value ratio and how is it calculated?

What are the requirements to qualify for a home loan?

Eligibility requirements for a home equity loan will vary by lender. As an example, Discover® Home Loans looks at several factors to determine if you are a qualified borrow, including:

  • Equity in your home: You will need to have enough equity available in your home to borrow from. This means that a loan amount between the borrowing limits of $35,000 to $300,000 added to all other loans secured by your property must equal below 90% CLTV for you to take out a home equity loan.
  • Qualifying credit score: You will need to meet your lender's minimum credit score requirements. For example, Discover Home Loans requires a credit score of 660 or above to qualify for a home equity loan. The higher your credit score is, the more likely you will be approved for lower interest rates on your loan.
  • Debt-to-income (DTI) ratio below 43%: When you’re looking to borrow money, it’s typically a good idea to make sure to have an idea of your debt-to-income ratio — the amount of your existing debt payments divided by your income. In general, mortgage lenders tend to make the best rates available to borrowers with a DTI ratio under 43%.
  • Documented income: Whether you’re earning a salary or hourly wages, self-employed, or work as a freelancer, you will need to provide documentation that indicates you make enough income to successfully pay back the loan.
  • Credit history: All lenders will want to see that you have a history of making payments on time. They may request copies of your credit report to assess this, so try to review your report to catch and resolve any inconsistencies or errors before applying for a loan.

In addition to this details, an appraisal report will be ordered by a lender to assess the value of your home. While this may be a cost charged back to you as the borrower, Discover Home Loans  charges no appraisal fees, origination fees, or costs at closing.

READ MORE: How to qualify for a home equity loan

Pros of home equity loans

A home equity loan can be a useful financial tool for homeowners who want to tap into the equity in their property to fund large expenses. This is because they have features such as:

  • Lower interest rates: Home equity loans typically have lower interest rates compared to other forms of credit, such as personal loans or credit cards. This is because the loan is secured using your home as collateral while other financing options are unsecured and not backed by any form of collateral.
  • Large loan amounts: Home equity loans may provide access to significant amounts of money, depending on the value of your home and the amount of equity you have built up.
  • Flexible use of funds: You can use the funds from a home equity loan for a variety of purposes, such as home improvements, debt consolidation, or paying for major expenses like college tuition or medical bills.
  • Tax-deductible interest: The interest paid on a home equity loan may be tax-deductible if the funds are used to buy, build, or substantially improve the home that secures the loan. Be sure to consult with a tax professional to understand options for your situation.

It’s important to speak with a personal banker who can evaluate your set of circumstances and guide you through the process of selecting a home equity loan.

Cons of home equity loans

There are some potential downsides to borrowing money using a home equity loan that you should be aware of, including:

  • Risk of foreclosure: Because your home serves as collateral for the loan, failing to make payments on a home equity loan can result in the loss of your property.
  • Closing costs and fees: Home equity loans can come with closing costs and fees, which can add to the overall cost of the loan. However, some lenders offer to cover these fees, so comparing your options before deciding may help you decide what works best for you.
  • Reduced home equity: Taking out a home equity loan reduces the amount of equity you have in your home, which might limit your financial flexibility and borrowing power in the future.
  • Possible impact on credit score: Applying for a home equity loan will result in a hard credit inquiry, which may temporarily lower your credit score. Additionally, having a large outstanding debt may impact your credit utilization ratio, which is a significant factor in determining your credit score.

In general, home equity loans are not always the best financing option for short-term expenses. For example, if you use a 10-year term home equity loan to purchase a car that you own for five years, you could end up paying more interest than you would with other financing options.

This is because you’re paying on the loan for a longer period than you likely would with a car loan. While a car loan may have higher interest rates, the term of the loan is not as long, so the financial benefit provided by using a home equity loan may be negligible in this case.

However, even with the example of car loans, there may be situations where a home equity loan is the right tool to help you achieve a brighter financial future. The best option will depend entirely on your unique set of circumstances. 

Benefits of a home equity loan

What can you do with a home equity loan? You can use the money you get from a home equity loan to pay for major expenses or life events, to consolidate high-interest debt, to improve your home, or pay for other things like education expenses. These loans may offer powerful financing opportunities for homeowners because of their flexibility.

Improve your home

Using the equity you’ve earned with a home equity loan to improve your home maybe  a smart way to leverage your funds. In fact, some improvement projects may increase your equity by increasing the value of your home.

High-interest debt consolidation

High-interest rates on unsecured debts can become a hurdle to becoming debt-free. Since home equity loans usually have lower interest rates than unsecured loans, using a home equity loan to pay off high-interest debt may be a smart move. You may enjoy a single lower monthly payment on your new loan compared to payments on interest and principal across multiple bills.

However, you may want to avoid using a home equity loan to consolidate high-interest debt if you are going to accrue new high-interest debt again.

Debt consolidation  may reduce financial stress, but using a home equity loan unwisely  can create more financial stress for you in the future if you obtain one for the wrong reasons.

Pay for life’s next big adventure

Instead of using a credit card or personal loan to pay for big-ticket items (like school tuition, a wedding, or a luxury vacation), you may want to consider using a home equity loan.

You could also use a home equity loan to pay off an unexpected expense. Home equity loans can enable you to use your big-ticket asset (your home) to pay for all kinds of big-ticket expenses.

Types of home equity loans

Home equity loans are usually offered in the following three types:

  • Home equity installment loan: This type of home equity loan becomes a second mortgage on your home. Home equity installment loans allow you to borrow a lump sum of money from the equity in your home, usually at a fixed interest rate. Repayment is determined by an amortization schedule based on a predetermined repayment period. Because interest rates on home equity loans are typically fixed, your monthly payment will remain the same for the life of the loan.
  • Home equity line of credit (HELOC): This type of home equity loan operates like a revolving line of credit and comes with a lot of flexibility. A HELOC lets you borrow what you need when you need it — but typically at a variable interest rate. Depending on your lender, you might only be required to make interest payments on the money you’ve borrowed during the draw period of the loan. Once the draw period expires, the balance of your HELOC is typically converted into an amortized installment loan. This means you’ll end up with a second mortgage in the amount of your HELOC balance, and you’ll be expected to make minimum monthly payments on interest and principal.
  • Cash out refinance: This type of home equity loan allows you to increase the amount of your current mortgage by refinancing and withdrawing additional cash from your home equity in a new loan. Instead of having two mortgages, a cash out refinance combines the amount borrowed from your equity with the principal of your existing mortgage into a single loan with one monthly payment and an updated interest rate and term.

How home equity loans work for you

Take inventory of your personal finances before obtaining a home equity loan. Your house is the collateral for your loan, so failure to repay can put your home at risk. Always borrow intelligently, and make sure you understand how home equity loans work before you get one. 

Gather your paperwork and then do your research, securing quotes from several different types of lenders. In addition to comparing the APRs, consider any additional fees and costs, and customer service features. With a little research and budget review, it’s easy to determine if a home equity loan is the right financial choice.

Where to go next

Please note: Discover Home Loans offers home equity loans and mortgage refinance opportunities, but does not offer HELOCs. 

The information provided herein is for informational purposes only and is not intended to be construed as professional advice. Nothing contained in this article shall give rise to, or be construed to give rise to, any obligation or liability whatsoever on the part of Discover Bank or its affiliates.

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